What Is Dollar-Cost Averaging?
October 23, 2020
By Rahul Iyer
Dollar-cost averaging gives investors the opportunity to make investments into one or more securities at intervals. With this strategy, each time an investment is made it is done at an equal dollar amount. This is done despite the direction of the stock market or the state of each security.
Dollar-Cost Averaging Explained
Dollar-cost averaging (DCA) is also known as the constant dollar plan. This strategy is implemented to reduce the potential negative impact of volatility on the overall investment. DCA involves dividing the total sum to be invested in securities over a period of time. At each interval, the investor will spend the same amount. These purchases are made regardless of the price of the assets. By implementing this strategy, you will remove much of the work that it takes to strategically time the market in an effort to purchase equities at the best price. It also removes the emotions from investing.
Over time, this strategy can be effective in building wealth. Its ability to neutralize volatility in the marketplace makes it a great strategy for those who are risk-averse. 401(k) plans serve as perfect examples of dollar-cost averaging. In these plans, securities are purchased at a set price on a monthly basis.
401(k) plans allow employees to choose the amount that they would like to invest each month in a set of mutual funds, stocks, and index funds. These plans make investment automatic as the employer handles the entire process without the employee having to do any work.
There are mutual fund and index funds that you can apply dollar-cost averaging to without going through a 401(k) plan. If you are a beginner in the realm of investing, dollar-cost averaging is a great place to start. There are also some dividend reinvestment plans that allow investors to dollar cost average by permitting regular equal contributions.
Word of Caution
Avoid applying the dollar-cost averaging method to individual stocks without assessing the company. Without having proper knowledge of the company, you may find that you are investing the same amount when you should really be seeking to dispose of those shares. If you do not have the time to constantly monitor the progress of companies or you do not feel competent enough to assess the financial reports of a company, it is wiser to apply this strategy to index funds. Index funds are far less risky than investing in individual stocks.