Dollar-cost averaging (DCA) is a strategy that can help reduce the impact of volatility when investing in securities. Instead of making a lump sum investment, investors can use dollar-cost averaging to break up the investments into equal smaller amounts over a certain period. Utilizing dollar-cost averaging can help an investor pay a lower average price for securities by taking advantage of market fluctuations.
For example, if an investor has $100 to invest, and a security costs $5, the investor can purchase 20 shares. Over the course of 10 weeks, let’s assume the price of the security fluctuates as follows:
If the security’s price ultimately increases to $6 in week 10, the total investment in the 20 shares would now be worth $120.
Now, let’s say that same investor took the $100 and decided to invest $10 per week over the course of 10 weeks instead:
|Week||Share Price||Shares Purchased|
Just like in the first example, the price of the security ultimately increases to $6 in week 10, but because the investor was able to take advantage of the security’s relative dip in price in weeks 4, 6, 7 and 9, the investor ultimately was able to purchase 21.6 shares over the course of 10 weeks. Instead of paying an average share price of $5 as in the first example, the investor utilizing dollar-cost averaging has an average share price of $4.90, and the total investment is now worth $129.60.
Dollar-cost averaging can also help an investor avoid mistiming the market, because the purchases are spread out over a longer period of time. This can take some of the emotion and stress out of investing by reducing the impact of short-term volatility when purchasing securities. Since it is extremely difficult, if not impossible, to predict market fluctuations in the short-term, dollar-cost averaging helps investors lessen the impact of poor market timing.
Utilizing dollar-cost averaging can be particularly beneficial in bear markets and during times of high market volatility, but it may not always provide the best returns over the long run. Markets do tend to rise over time, so spreading out an investment over a longer period when the market is steadily increasing can mean the investor will be buying into the security at an increasing price. The investor could be forgoing the gains he or she would have gotten with a lump sum investment.
Another potential drawback to the dollar-cost averaging approach is that it can open the investor up to additional trading fees. In recent years, the trend has been for brokerage firms to reduce trading fees or eliminating them altogether, so while this is becoming less of an issue, it is still something to keep in mind.
Dollar-cost averaging is also a useful strategy for investors who want to start investing with smaller amounts of money and don’t want to wait until they have a large sum saved up. In fact, most people who contribute to a 401(k) plan through their employer are already utilizing dollar-cost averaging since the funds are generally invested on a recurring basis.
Whether as an alternative to lump sum investing or as a way of putting smaller amounts of money to work immediately, dollar-cost averaging can be a useful strategy to help build wealth over time.
Authored by Dennis Culver, Insight Wealth Strategies
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.