Dollar-cost averaging (DCA) is an investment strategy where you invest the same amount at regular intervals regardless of asset prices.

Long-term, DCA can lower your average purchase price, minimize the impact of volatility and reduce the temptation of market timing. Investors who dollar-cost average may also find that they “remember” to invest thanks to automated contributions.

Despite its benefits, this strategy isn’t a good fit for everyone. Here’s what to know.

Understanding dollar-cost averaging

Dollar-cost averaging involves making regular investment contributions regardless of market volatility. Though prices inevitably rise and fall, you continue to invest no matter which way they move. That way, you buy the highs, lows, and in-betweens, potentially lowering the impact of volatility – and your average purchase price.

Due to these benefits, dollar-cost averaging is often a key component of passive investment strategies. It may encompass a wide range of securities and assets, including:

• Stocks
• Bonds
• Mutual funds
• Index funds
• Exchange-traded funds (ETFs)

You can also view dividend reinvestment programs (DRIPs) as a type of DCA. With DRIPs, your broker reinvests dividends as they become available, regardless of current market prices.

How does DCA work?

The idea behind DCA is that security prices generally rise over time. (In fact, that’s a primary reason to invest.) Unfortunately, short-term market volatility makes it impossible to accurately predict when an investment will move and in which direction.

But by investing smaller amounts at regular intervals, you’ll be  investing when prices are low and high.

When prices are down, your contributions purchase more shares; as prices rise, your contributions buy fewer. In time, this method can smooth out your average purchase price, giving you more room for potential gains when the price rises over the long term.

In fancy investor speak, DCA can lower your long-term cost basis, reducing losses while generating greater gains.

However, dollar-cost averaging only works when the security’s price fluctuates up and down. For instance, if you invest throughout a bull run, you may spend less than if you purchased at the peak. That said, you’ll spend more long-term than if you’d invested a lump sum when the bull run began.

How to calculate dollar-cost average

Calculating your average asset cost under DCA is just like calculating any other average. You simply tally your total investment value and divide the result by the number of shares you’ve purchased.

The calculation looks like this:

Dollar-cost average = total investment value / number of shares purchased

For instance, say that you invest $20,000 into Future Amazing Stock over 5 years. In that time, the per-share price fluctuated between $50 and $150. Amid this high volatility, you’ve managed to accumulate a hefty 175 shares.

To calculate your dollar-cost average, you simply plug those numbers into our equation:

DCA of Future Amazing Stock = $20,000 invested / 175 shares = $114.29 average purchase price

Over five years, you spent an average of $114.29 per share, despite a $100 difference in Future Amazing Stock’s highest and lowest prices.

Does dollar-cost averaging work?

Whether DCA “works” depends on how you define success.

Over time, DCA strategies have proven to lower investors’ average per-share costs, particularly compared to market timing.

But you’ll also spend more per share than if you’d dropped a lump sum at an investment’s trough.

Unfortunately, knowing when an investment will trough or peak is the definition of market timing. And though many investors have tried as they might, market timing remains virtually impossible – and often expensive to boot.

To achieve success with DCA, it helps to define:

• How much you plan to invest in total (or for how long)
• How often you want to invest, such as weekly, monthly, etc.
• The dollar value of each investment
• Whether you’ll pause your strategy during particularly extensive bull or bear runs

Additionally, some types of investors find DCA strategies more beneficial than others. Often, beginning investors who lack experience and expertise can benefit from dollar-cost averaging, particularly when ETFs and Investment Kits are involved.

Long-term investors who plan to maintain a passive investment strategy for years or even decades may also see greater gains with DCA.

Is dollar-cost averaging a good idea?

DCA can be a good idea for investors who want to lower their average purchase price and avoid timing the market. Here’s what makes the strategy so valuable for some.

Lower long-term losses and costs

One of the biggest perks of DCA is its impact on your long-term costs. As you make regular asset purchases, you can smooth out your returns by generating lower losses and greater gains.

Removes temptation to time the market

Market timing – or trying to invest only when the market peaks or troughs – remains virtually impossible and incredibly risky. Since you’re always buying, DCA removes the temptation to try market timing. When prices peak, you’ll be there; and when they bottom out, you might more than make up the difference.

Greater emotional resilience to market volatility

Those who dollar-cost average may find that they’re less emotionally impacted by market volatility. Stomaching a market crash isn’t easy for any investor – it’s hard watching your hard-earned funds flush down the drain. But if you’re used to buying the highs and the lows, it’s easier to wait out short-term volatility.

Increased accessibility for low-dollar investors

If you don’t have tons of cash lying around, DCA encourages regular contributions regardless of market performance. While $25 per week doesn’t seem like much, you’ll still buy $1,200 more in assets per year than if you invest nothing.

Establishes good investment habits

DCA also encourages automating your investments so you never miss a contribution. In the process, you’ll build your financial discipline and reap the future benefits of your good decision-making now.

Possible problems with dollar-cost averaging

Though it has its benefits, dollar-cost averaging may not suit every investor’s long-term financial plans.

Increased long-term costs

For instance, making frequent asset purchases may result in more or higher transaction costs, depending on your brokerage. If you’d invested the same value in a lump sum upfront, you might contend with just one fee instead of dozens. (Though as brokers move toward transaction fee-free setups, this worry has become less relevant.)

Price movements may not work in your favor

Additionally, you’ll want to consider an important what if: the possibility that prices could only continue going up. In such a scenario, DCA can still lower your long-term costs by ensuring you don’t only buy at the peak. But once again, if you’d invested a lump sum upfront, you’d reap greater benefits due to making one larger, cheaper purchase.

In reverse, you might consider the impacts of leveraging DCA in a long-term bear market. On one hand, purchasing at continually-falling prices lowers your cost basis. But if you’d saved your dollars to buy in at the bottom, you could theoretically increase your long-term returns when the market rises.

Timing price movements is just timing the market

However, changing investment strategies on a dime because you think the financial winds are shifting wanders into market timing fairly quickly.

While you may fare better pausing your investments for a short time, it’s impossible to say when you should start and stop.

All told, it’s important to remember that DCA doesn’t guarantee gains or missed losses. Instead, it assumes that prices will fluctuate short-term while rising long-term, allowing you to lower your average purchase price without investing everything you own upfront.

How to take advantage of DCA in your own account

If you’re contributing to a retirement account like your 401(k) or IRA regularly, you’re probably dollar-cost averaging without even knowing it.

Each time you withhold your retirement contribution from your paycheck, your plan administrator invests regardless of asset prices. Over time, this strategy builds a large portfolio that (hopefully) appreciates over time.

Investors also commonly use DCA – whether they know it or not – when they invest in mutual or index funds on a regular basis.

The reason that DCA shows up so commonly in fund-based investments is that it’s generally most effective when applied to your broader portfolio, rather than individual securities. As you average out the purchase price of dozens or hundreds of investments, you stand to lower your cost basis and diversify at the same time.

At Q.ai, we don’t recommend stock picking anyway. Instead, we suggest exploring our variety of diversified Investment Kits for your dollar-cost averaging designs.