What is dollar cost averaging (DCA)?

Denise buys $1,000 of the same stock for a total of 50 shares. She continues to invest $1,000 per month in the stock regardless of the price. At the end of the fifth month, will Denise’s portfolio be worth more or less than John’s?

It might, but then again it might not. This is because stock prices are fluid. They don’t stay at the same price for more than a minute, let alone a whole day or an entire month.

You don’t have to be an experienced investor to have heard the phrase, “buy low and sell high”. It’s an investment philosophy that sounds simple enough. But the reality is different. Stock markets are volatile and even the most experienced investors may have difficulty timing the market.

Sadly, it's this relationship between risk and reward that can keep investors with a low-risk tolerance away from the market.  The thought being you can't lose money you don't put at risk. While that's true, you can't make money either. That's where dollar cost averaging comes in.

This article will define dollar cost averaging, go over different examples of dollar cost averaging. We’ll also review the benefits and the potential drawbacks of dollar cost averaging.

How dollar cost averaging works

Let’s go back to our example.

John makes a one-time purchase of $5,000 for a stock priced at $20 per share. After five months, the stock is worth $35 per share. His investment is now worth $8,750. What you don’t see however is what was happening with the stock in the in-between months? Was it riding at a slow and steady pace, or was it moving up and down. Did it ever fall below $20 per share? Did it ever climb above $35 per share? If John was taking a buy-and-hold strategy, he is conditioned not to care about short-term price movement. If he believes in the stock, he will hold onto it understanding that price movement is a reality of stock ownership.

But to understand, which investor may have really “won the trade”; we’ll take a closer look at different scenarios for the stock.

Scenario #1

Using this scenario, we can determine how much Denise’s portfolio would be worth.

Over time, Denise purchased 224.12 shares (50 + 55.55 + 50 + 40 + 28.57). At $35 per share, her portfolio would be valued at $7,844.12. That’s just over $900 less than the value of John’s portfolio. However, Denise paid an average of $23.60 per share, whereas John paid a flat $20 per share.

But let's look at another example. Let's say the stock was trading in a tight range based on bad news but had a surge in the final month when the company released a stellar earnings report. The table might look something like this.

With these stock prices, Denise’s purchases would look like this:

Over time, Denise purchased 233.01 shares. At $35 per share, her portfolio would be valued at $8,155.35. Better? But still, almost $600 less than the value of John’s portfolio and she still paid slightly more for her shares than John on average, $20.70. Let’s look at one more example.

In this example, Denise would have purchased 256.84 shares that are now worth $5,201.01. John’s 250 shares would be worth $5,062.50. Denise would be ahead. Furthermore, she would have paid an average of $19.50 per share compared to the $20 per share paid by John.

The benefits and drawbacks of dollar cost averaging

These examples illustrate the benefits and the drawbacks of dollar cost averaging. First, we’ll take a look at the benefits. When stocks are trading in a tight range or declining, dollar cost averaging allows you to buy shares when they’re “on sale”. Think of it like going to the grocery store. You can buy a certain item, say peanut butter, any day of the week. But when you buy it on sale, you’re getting the same quantity of the item, but you’re paying less per ounce. In fact, grocery stores frequently have sales that encourage consumers to “stock up and save” with the theory being that you buy more of an item that you frequently use while it’s on sale and therefore save money over time.

This brings up another benefit of dollar cost averaging. It’s an investing strategy that can be an effective hedge against falling prices. Let's say in our example, the price of shares in the first month was $35. John would have purchased approximately 143 shares. If the stock ended at $20, the value of his portfolio would be $2,857.14. Assuming over the same time period, Denise was able to purchase the same total of 224.12 shares; she would have $4,482.40, a much smaller loss than John.

The other benefit of dollar cost averaging is that developing a consistent investing habit takes the guesswork out of “when” to buy a stock. Many investors have the time, and the enthusiasm, to actively trade stocks. They not only embrace the risk, but they are usually pretty good at it. Some may even engage in day trading where they are seeking to profit from very small movements in a stock. Dollar cost averaging is a conservative, low-risk strategy that doesn't ensure an investor will not lose money, but the consistency of making regular stock purchases no matter the cost has proven to have a positive impact on a portfolio.

However, the object of every investor is to find stocks that are going to increase in value, and that illustrates the drawback of dollar cost averaging. Our example above was very simplistic. If only all stocks behaved in a neat and predictable manner. The reality is they don’t. As our example showed, there are times when buying a large number of shares all at once (or lump sum investing) and then holding them over time will help an investor reap a higher return. It would be analogous to buying a jar of peanut butter and watching it magically grow in size. So over time, you are actually getting even more for your money.

Using dollar cost averaging does not prevent you from benefiting when stocks rise, but it can mean that you are not getting the same increase because when share prices are high, your dollars are buying less.

The bottom line on dollar cost averaging

In a perfect world, investors would be able to time their buying and selling activity to ensure that they will always buy low and sell high. In reality, although it is possible to time the market every now and then, it is virtually impossible to do this on a regular basis.

This is what makes dollar cost averaging an attractive option, particularly for novice investors. By using a dollar cost averaging strategy, investors pay the same amount of money to buy shares of a security on a regular basis, regardless of what that price may be at a given time. Dollar cost averaging is frequently used by employees who participate in their employer’s 401(k) plan because they can set aside a fixed percentage of their pre-tax dollars to make regular contributions. Since the vast majority of these plans do not allow participants to purchase individual securities, dollar cost averaging is found frequently with mutual fund and exchange-traded fund (ETF) investors.

One of the advantages of dollar cost averaging is that it can be a hedge when the markets are trading in a tight range or declining because you have the opportunity to buy shares at a discount. It’s also an effective strategy for investors who have a low-risk tolerance because the consistency of buying shares rewards them for continuing to buy shares regardless of the overall direction of the market.

On the downside, investors who use dollar cost averaging will frequently miss out on the volume gains that can come when an investor buys a large number of shares at a low price and receive a large gain when the shares rise.

No investment strategy is without risk. Dollar cost averaging will not prevent an investor’s portfolio from losing value. And in many cases, an investor who invests a lump sum on a security will see a higher return. But for investors with a low-risk tolerance who have a long window towards their investing goal, dollar cost averaging can be an effective strategy.