Price fluctuation is an inherent feature of the stock market also termed volatility. There exist few investment strategies to lower the impact of volatility and the risk involved. One such strategy is dollar-cost averaging which avoids panic and predictive buying behaviour of investors.
This article sheds a spotlight on dollar-cost averaging meaning, its benefits, limitations, and an example for better understanding.
Dollar-Cost Averaging
Dollar-cost averaging is an investment strategy used to minimize the impact of price volatility. DCA is also called the constant dollar plan. According to this strategy, investors invest a certain amount of money in financial security at regular intervals, regardless of market conditions. This strategy is against the technique of timing the market. Investors trying to time the market tend to predict the future price movements and buy more of the securities when prices are lower to gain more when prices go upward.
Dollar-Cost Averaging strategy avoids investing lump sums in a single attempt when prices are lower. The reason is that lump-sum investing can be a risky move as the future is highly uncertain. Instead, investors break down a large amount of money into smaller parts and buy the financial assets regularly at a fixed schedule. Whether the security prices are higher or lower, the investors keep going. This means, they end up purchasing more shares when prices are lower, and fewer shares when prices are higher, without attempting to predict future price movements.
DCA is more often applied to stocks, mutual funds, and exchange-traded funds. It is suitable for those investors who are more concerned with risk minimization than earning huge gains. Passive investors who cannot track the market regularly may find DCA a significant tool. Novice investors can stay committed to their investment goals as it promotes disciplined investment and eliminates emotional bias. Dollar-cost averaging makes the investment affordable for those who do not have a large amount of money to invest.
One of the examples of DCA is the 401(k) plan which is a retirement savings plan in the U.S. According to this plan, the employee determines an amount from the salary which he/she wants to invest in mutual funds or index funds.
There is no standard amount and interval for investing using DCA. Investors can decide the amount to be invested depending on their convenience and also choose the frequency of investment i.e. weekly, biweekly, monthly, etc.
Limitations of Dollar-cost Averaging
There is no guarantee that Dollar-cost averaging will make more money as compared to lump-sum investing. Additionally, DCA leads to frequent transactions which means transaction costs will be higher than lump-sum investing.
In dividend stocks, higher investment leads to higher dividends. Therefore, lumpsum investment has a higher potential to earn from those stocks as compared to DCA. The investment performance depends more on the stocks opted for investment.
A real-world example of Dollar-Cost Averaging
Frenny works at ABC Company and has a 401(k) plan. Her monthly salary is $500. She decides to allocate 10% i.e. $50 of her salary to the employer’s plan. She opts for S&P 500 index fund for investment purposes. $50 from her salary will go towards buying units of the index fund every month, irrespective of its price. Here is the summary of her investment for 5 months.
| Time | Invested | S & P Index fund price | Unit bought | Total Units |
|---|---|---|---|---|
| Month 1 | $50 | $10.50 | 4.76 | 4.76 |
| Month 2 | $50 | $9.75 | 5.13 | 9.89 |
| Month 3 | $50 | $10.50 | 4.76 | 14.65 |
| Month 4 | $50 | $11.25 | 4.44 | 19.09 |
| Month 5 | $50 | $10.00 | 5 | 24.09 |
Here, even with the price fluctuations over five months, 24.09 units are purchased at $250 investment, this means the average cost per unit is $10.37. If Frenny had invested a lump sum of 250$ in the first month, she would end up with 23.81 units, i.e. less than the current number of units. Furthermore, the fund price was higher than her average price in three out of five months.
What is an Example of Dollar-Cost Averaging?
An investor, Prateek, has $400 and he wants to spread out his investment over four months i.e. $100 every month. He is willing to invest in a stock of company XYZ which is currently traded at $20 per share. With $100 for the first month, he will be able to buy 5 shares. Now, in the next month price goes to $25 per share. Therefore, he will be able to buy only 4 shares. Next month price drops to $10 per share. He will, then, be able to buy 10 shares. Next month again price goes to $25 per share, so he will buy 4 shares.
With a total investment of $400, he could buy 23 shares. His average cost per share is $17.39. If he had invested a lump sum in the first month, he would have only 20 shares.
Thus, Dollar-cost averaging is an investment strategy of investing a particular amount in specific security regularly, irrespective of per-unit price. DCA is particularly beneficial for those investors who cannot adjust their portfolios to the market conditions. Though the strategy is less risky, the returns investors get are moderate too. One of the loopholes is that investors can buy shares even when it is not favourable.
