Dollar-cost averaging or DCA is a fundamental investment strategy that involves purchasing assets in small amounts, at regular intervals.
Let’s take a closer look at how it works & when it should be used…
What is Dollar-Cost Averaging?
With DCA, an investor first decides on the total amount they want to invest and then invests it in smaller, equal installments over a specific period of time. For example, if an investor has $500 to invest, they may purchase $100 every month rather than $500 all at once.
Timing the market is difficult and investors shouldn’t expect to time the market perfectly. DCA helps to remove timing from the equation. No one will catch the absolute top, or the absolute bottom. But when making larger investments, price fluctuations matter. Dollar-cost-averaging helps to reduce the impact of volatility and the risk of making a poorly-timed investment. It can also help take emotions out of the decision-making process.
However, dollar-cost averaging doesn’t eliminate risk. The idea is simply to minimize the risk of bad timing. Other factors must be taken into consideration too.
When should DCA be used?
The key thing to note about DCA is that an investor shouldn’t always be dollar-cost averaging. Timing is important. DCA should typically be used during times of panic and stress in the market, when things are undervalued.
By buying when others are selling, DCA can potentially help an individual take advantage of buying low and selling high. But DCA is not only useful on the way in. Someone may use DCA on the way out too, when taking profit. It’s almost impossible to catch the absolute bottom, but DCA offers a way to remove timing from the equation.
Again, an investor shouldn’t always use DCA unless they intend to do so for 50 to 60 years.
