What is Dollar Cost Averaging and Why should I Care?
Dollar Cost Averaging (DCA) is a method of investing in which an individual puts an identical amount of money into their investment account (401k, IRA, Brokerage, etc.) at a regular interval (i.e. weekly, monthly, etc.) The result of this structure is that every time you deposit money into the account, the shares purchased differ because their price is changing. There will be some shares purchased at lower prices and some shares purchased at higher prices so over the long-term they average out, hence the name “Dollar Cost Averaging”.
The advantages of this method include the following:
1. It creates an automated structure in which you invest, ensuring you’re investing on a consistent basis and battles inertia because as an investor, you don’t have to go in and choose to invest at certain periods of time
2. From a personal cash flow management perspective, placing smaller amounts each week/month/etc. can be more ideal than placing an entire lump sum at one time
3. DCA combats the short-term risk of changing prices because you are locking in shares at various prices that average out
Let’s take a look at an example:
John decides he wants to set up DCA so he talks to his financial adviser, Pam and they decide he can contribute $100/mo. to his Roth IRA. Pam helps John set this up by sending paperwork that connects his bank account directly to his Roth IRA and schedules a deposit from his bank into the Roth IRA on the 15th of every month. Let’s see how this works visually:
As you can see, in this situation, investing at intervals each month actually brought the average price down and allowed John to purchase more shares than if he would have contributed a lump sum amount in January.
Assumptions: (1) This does assume a little volatility over nine months. If the stock would have only risen over time, John would have paid more and purchased less shares each month. (2) This is assuming John is purchasing one company’s stock. This is unlikely and if you decide to pursue DCA, make sure you are well-diversified or working with a financial planner that can invest your money appropriately.
Should you take advantage of Dollar Cost Averaging?
Always consult with your financial planner but this method is ideal in volatile times to smooth out the risk; times like now when the Coronavirus is dragging the market down lower than it’s been in years with fluctuating prices daily. Consider it as an option if it makes sense in your financial plan.
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