Dollar-Cost Averaging (DCA): What It Is, How It Works, and Example

What Is Dollar-Cost Averaging (DCA)?

Investing can be challenging, as even experienced investors who try to time the market can come up short. Dollar-cost averaging (DCA) is an investment strategy that removes the uncertainty of market timing by adhering to a fixed investment schedule. It also supports an investor’s effort to invest regularly.

DCA involves investing the same amount of money in a target security at regular intervals over a certain period, regardless of price. By using DCA, investors may lower their average cost per share and reduce the impact of volatility on their portfolios. In effect, this strategy eliminates the effort required when attempting to time the market to buy at the best prices.

How Dollar-Cost Averaging (DCA) Works

Dollar-cost averaging (DCA) is a simple tool that an investor can use to build savings and wealth over the long term. It's also a way for an investor to ignore short-term volatility in the broader markets.

A prime example of long-term DCA is its use in 401(k) plans, in which employees invest regularly regardless of the price of the investment.

With a 401(k) plan, employees can choose the amount they wish to contribute as well as the investments offered by the plan in which to invest. Then, investments are made automatically every pay period. Depending on the markets, employees might see a larger or smaller number of securities added to their accounts.

DCA can also be used outside of 401(k) plans. For instance, investors can use it to make regular purchases of mutual or index funds, whether in another tax-advantaged account like a traditional individual retirement account (IRA) or a taxable brokerage account.

DCA is one of the best strategies for beginning investors looking to trade exchange-traded funds (ETFs). Additionally, many dividend reinvestment plans (DRIPs) allow investors to dollar-cost average by making purchases regularly.

Benefits of DCA

• It can lower the average amount you spend on investments.
• It reinforces the practice of investing regularly to build wealth over time.
• It’s automatic and can take concerns about when to invest out of your hands.
• It removes the pitfalls of market timing, such as buying only when prices have already risen.
• It can ensure that you’re already in the market and ready to buy when events send prices higher.
• It takes emotion out of your investing and prevents you from potentially damaging your portfolio’s returns.
  

Who Should Use DCA?

The investment strategy of DCA can be used by any investor who wants to take advantage of its benefits. DCA may be especially useful to beginning investors who don’t yet have the experience or expertise to judge the most opportune moments to buy. It can also be a reliable strategy for long-term investors who are committed to investing regularly but don't have the time or inclination to watch the market and time their orders.

However, DCA isn’t for everyone. It isn’t necessarily appropriate for those investing in time periods when prices are trending steadily in one direction or the other. Be sure to consider your outlook for an investment, plus the broader market, when deciding to use DCA.

Special Considerations

It’s important to note that DCA works well as a method of buying an investment over a specific period of time when the price fluctuates up and down. If the price rises continuously, those using DCA end up buying fewer shares. If it declines continuously, they may continue buying when they should be on the sidelines.

Using this strategy to buy an individual stock without researching a company’s details could prove detrimental as well. That’s because an investor might continue to buy more stock when they otherwise would stop buying or exit the position.

For less-informed investors, the strategy is far less risky when used to buy index funds rather than individual stocks.

Investors who use a DCA strategy will generally lower their cost basis in an investment over time. The lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price.

Example of DCA

Jordan works at ABC Corp. and has a 401(k) plan. They receive a paycheck of $1,000 every two weeks. Jordan decides to allocate 10% or $100 of their pay to their employer’s plan every pay period.

They choose to contribute 50% of their allocation to a large-cap mutual fund and 50% to an S&P 500 index fund. Every two weeks, 10%, or $100, of Jordan's pretax pay will buy $50 worth of each of these two funds, regardless of the fund’s price.

The table below shows half of Jordan's $100 contributions that went to the S&P 500 index fund over 10 pay periods. Throughout 10 paychecks, Joe invested a total of $500, or $50 per week. The price of the fund increased and decreased over that time.

The Results of DCA

Jordan spent $500 in total over the 10 pay periods and bought 47.71 shares.

They paid an average price of $10.48 ($500 / 47.71).

Jordan bought different share amounts as the index fund increased and decreased in value due to market fluctuations.

The Results if Jordan Spent One Lump Sum

Say that, instead of using DCA, Jordan spent their $500 at one time in pay period #4. They paid $11 per share.

That would have resulted in a purchase of 45.45 shares ($500 / $11).

There was no way for Jordan to know the best time to buy. By using DCA, however, they were able to take advantage of several price drops despite the fact that the share price increased to over $11. They ended up with more shares (47.71) at a lower average price ($10.48).

How Will I Use This in Real Life?

If you have a stock you’d like to invest in but aren’t clear on when the best time to buy is, DCA can help. By following a simple routine of automatic stock purchases, whether weekly, biweekly, or monthly, DCA allows you to invest consistently without needing to analyze the market or wait for a dip (which can be difficult to predict). This is particularly helpful if you’re new to investing.

You can use DCA to purchase individual shares and ETFs or to make regular contributions to your IRA. The strategy is to choose a fixed amount you’re comfortable with and stick to it, regardless of how the market is performing. This helps average out the cost of your investments over time while simultaneously removing the emotional aspects of investing, allowing you to build your portfolio steadily.

The Bottom Line

Dollar-cost averaging (DCA) is a simple and straightforward way of investing that reduces the emotional stress of trying to invest at the right time. By sticking to a fixed investment schedule and amount, you'll naturally buy more shares when the price is low vs. high.

DCA may not be a perfect investment strategy, as it doesn’t protect against market risk. However, it allows investors to stick with regular investing, build up a portfolio over time, and decrease the anxiety of trying to time the market.