How To Dollar Cost Average

by RJ

in Investing

111590985_ff46cb1600Investing isn’t a highly complex formula. Instead, think of investing as a simple habit like brushing your teeth. To succeed you need to ingrain that habit.

The purpose of this post is to outline how you can make investing a habit using dollar cost averaging.

What is Dollar Cost Averaging?

DCA is the financial term for someone who invests on a set schedule, i.e. weekly, monthly, and yearly, no matter the movement of the market. For example, having $50 a month automatically withdrawn from your bank accounted and invested into an index fund.

The opposite of DCA would be to market time. If you think the market will go up you buy, if you feel the market is going to go down you sell or hold.

For the remainder of this post I will make two assumptions; you’re likely investing a portion of your income rather then a lump sum, and you’re investing in a diversified portfolio, like an index fund, rather than a single stock.

There are two different ways you can start to dollar cost average into your portfolio.

  1. Flat Percentage – This method is the preferred method of dollar cost averaging because you learn to pay yourself first. For example, you automatically invest 10% of your income each month. If you invest in your employer’s 401K, you’re likely already using this method.
  2. Flat Amount – Instead of taking a percentage like 10% of income, you can decide to invest a specified dollar amount each month. For example, investing $416 each month to max out your IRA for the year. This method is great for reaching short and medium term goals.

Advantages of Dollar Cost Averaging

The biggest advantage of using DCA is investing becomes a habit.

Other advantages include:

  • Reduces risk
  • Buy when prices are low
  • Always in the market for the upswings
  • Fast recovery in recessions
  • Don’t have to worry about market timing

Disadvantages of Dollar Cost Averaging

DCA isn’t the end all be all of investing. The primary concern of DCA is you miss an upswing in the market because all of your money isn’t invested. However, this is only applicable to those who have a lump sum to invest. If you’re like most young investors, you’re investing your income instead of a lump sum of money.

Other disadvantages of DCA include:

  • More transactions but only applicable if you’re charged transaction fees
  • Forget to rebalance because DCA is on autopilot (most likely to happen in a 401K)

Effects of Dollar Cost Averaging in a Bear Market

Below is an example of the effects of DCA into a declining market.

Dollar Cost Averaging into Bear Marketing

Month IRA Contribution Price Per Share Shares Purchased
1 416 50 8.32
2 416 48 8.67
3 416 46 9.04
4 416 44 9.45
5 416 42 9.9
6 416 40 10.4
  2496 45 55.78
  Total Contributions Average Price Per Share Total Shares Purchased

Effects of Dollar Cost Averaging in a Bull Market

Below is an example of the effects of DCA into an increasing market.

Dollar Cost Averaging into Increasing Market

Month IRA Contribution Price Per Share Shares Purchased
1 416 50 8.32
2 416 52 8
3 416 54 7.7
4 416 56 7.43
5 416 58 7.17
6 416 60 6.93
  2496 55 45.56
  Total Contributions Average Price Per Share Total Shares Purchased

How to Dollar Cost Average Lump Sums

The argument against DCA is that you miss an upswing in the market, which I mentioned only makes sense if you’re investing a lump sum.

If you have a lump sum to invest, in my opinion, if you’re investing for the right reasons, go ahead and invest all at once or DCA over a ¬†short time period i.e. less than 2 years.

If you understand that stocks can lose 50% in a year, you have to be willing to accept that loss or else you have not identified your risk tolerance. Identifying financial goals and risk tolerance should be first on your list, not last.

Make investing a habit, instead of a chore. Start dollar cost averaging today to increase your chances of success.

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