Dollar Cost Averaging (DCA) is a simple systematic approach to buying investments. DCA tempers the volatility of your investment portfolio by breaking down large investments into smaller ones over time.
Instead of buying a large single investment all at once, the intended purchase is parceled into smaller pieces and spread over a period of time. Let’s review what that entails.
The following video best illustrates the concept:
What you need to know
Investors are often worried that immediately after making a large investment, the price of that security or stock will fall, and they will incur a loss that must then be overcome.
I’ve seen it time and again. Nervous investors keep a portion of their holdings in cash or an underperforming investment that is not aligned with their investment strategy.
Here is an example of how DCA works:
- An investor wants to make a $60,000 investment in a single mutual fund
- With a share price hovering around $20, we can buy around 3,000 shares
- The rationale behind this purchase is a buy-and-hold strategy to collect dividends to reinvest, and produce a long-term capital gain
- Over the next 3 months, 3 equal purchases of the mutual fund will be made
- On August 1st, 1,000 shares are purchased at $20/share = $20,000
- On September 1st, 1,110 shares were bought at $18 = $19,980
- On October 1st, 950 shares were bought at $21= $19,950
- A total of 3,060 shares bought for $59,930 at an average price of $19.58
Dollar Cost Averaging allows investors to mitigate some of the short-term risk associated with price drop immediately after purchasing. Without DCA, if an investor fully buys-in and the price immediately falls, regret sets in.
With DCA, an immediate price drop as outlined in the example above allows more shares to be purchased for the same lump-sum amount. This can be especially helpful for a buy-and-hold strategy with an equity mutual fund.