I think everyone who reads my articles agrees investing money in the market is generally a smart idea. However, as we have all seen in 2022, the market can be very volatile. What if you want to invest but just don’t have the stomach for the roller coaster ride? Don’t worry. Take cover in the average.
There is a key way to reduce unpredictability when investing. This method is called Dollar Cost Averaging (DCA). DCA is investing equal amounts of money, spaced out over regular intervals, regardless of price (Investopedia). In this article, I am going to explain how DCA works, and the overall benefits of it.
DCA is a valuable trick to know as a rising investor. And it’s not too difficult to understand. The simple approach is to invest the same amount of money over consistent periods of time. This allows the investor to buy at specific time points knowing that over time, they are buying the ups, and downs, of the market, to get the “average”. However, to better understand this, let me provide you with an example from Investopedia. Let’s say in January, a stock was at 20 dollars per share. By February it was at 16 dollars per share. By March, it was 12 dollars per share. By April, it was 17 dollars per share. By May, it was 23 dollars per share. An investor buys 1,000 dollars into the stock at the start of each month while the number of shares bought varies. In January, 1,000 dollars bought 50 shares. In February, it bought 62.5 shares. In March it bought 83.3 shares. In April it bought 58.2 shares. In May it bought 43.48 shares. Just five months after beginning to contribute to the stock, the investor owns 297.48 shares. The investment of 5,000 dollars has turned into 6,840 dollars. To understand this more, visit the link from Investopedia (Investopedia.com). Although investing without using DCA could have resulted in a higher profit, it also could have resulted in lost money. As I mentioned earlier, the goal of DCA is to create steady, long-term profit.
There are two main reason to use DCA. The first is managing emotional investing. DCA is an established consistent method. Therefore, it allows you to focus on the goal at hand, rather than the hot takes and predictions within the market (Corporatefinanceinstitue.com). Like I said earlier, a big piece of DCA is to eliminate volatility; well limiting emotional investing most certainly helps.
Another benefit of DCA is that it reduces bad timing. As great as professional stock journalists are, they can’t predict every rise or fall in the market. Instead of investing a large amount of cash into the market at one time, which with bad timing could result in heavy loss, DCA spaces out investments which will smoothly bring down the risk of bad timing (Corporatefinanceinstitue.com).
As great as DCA can be, it’s not perfect. To master DCA one must understand the challenges it presents. So, here is a list of the pros and cons of dollar cost averaging (Investopedia.com). Along with that, this article from Investopedia explains how to best use DCA (Investopedia.com). I strongly recommend reading both these articles to establish a strong foundation on DCA.
One note here; if you are participating in a 401K, you are already using the DCA method. For some people, this is their primary method of investing. If it is part of an investment mix, it adds a level of calmness to an investor’s overall strategy.
There are many great tools to have as a rising investor, and DCA is an important one to have.