One of the greatest misconceptions surrounding investing is that it requires a large sum of money to get started. And typically that misunderstanding is then followed by the fear that if you invest all your hard earned money you risk losing it due to a down turn in the market.
However, if you’re new to investing and want to get started by taking a more passive approach to investing and minimize your risk, Dollar-Cost Averaging (DCA) may be the right strategy for you.
Dollar-cost averaging is the process of investing a consistent sum of money into an investment or security over a period of time (typically long-term), regardless of the price of that security.
For example if you were to invest $100 each month in ABC stock, DCA would look something like this:
In its simplest form dollar-cost averaging is a way to start investing without making a one-time lump sum payment into an investment. In addition it provides a methodology for lowering the average cost of your investment – like the shares of ABC stock shown above.
Depending on your investment strategy, DCA may be an investment strategy you can leverage as part of your overall strategy. Here are the pros and cons of dollar-cost averaging.
Investing can be a very emotional experience. Much of this is due to the fact that any form of investing requires risk, and that risk may involve you losing your money. By taking a consistent and passive approach to investing (set it and forget it) DCA allows an investor to distance themselves from the fluctuations in the market that may create an enormous amount of anxiety.
Unless you’re an avid investor, knowing when and when not to invest in a particular security can be like playing Russian roulette. Investing a large sum of money at the wrong time could prove to be a disaster.
DCA is based on the assumption that over time the value of your investment will rise. By cost averaging over a period of time DCA mitigates your risk to large fluctuations in the market. This can help avoid the pitfalls of making a bad investment decision due to a miscalculation in the market.
A Place to Start
Dollar-cost averaging does not require a lot of money to get started, the key is being able to invest on a consistent basis. DCA is an ideal solution when you can leverage payroll deduction or direct deposit, like when you contribute to an employer sponsored 401(k) or an IRA.
Lump Sum Investments
Because DCA takes a passive approach to investing, it foregoes the opportunities afforded by making a lump sum investment. If the stock or mutual fund you’re investing in falls in price in the short-term, you may miss the opportunity to take full advantage of the potential gains when the price goes back up.
Good News Passive Approach, Bad News Passive Approach
Part of any investment strategy is the ability to make good, knowledgeable investment decisions. The “set it and forget it” approach to DCA can have the effect of making an investor vulnerable to what is actually happening with their investment, because they are not actively involved.
In the example above we are making periodic investments in ABC stock. However, if over time ABC Company’s stock value decreases due to poor financial performance and you continue to invest in it, you could find yourself owning a portfolio of stock that is worth less than when you started. A more active approach to investing would allow you recognize the short-comings of ABC stock and adjust your portfolio before the stock depreciates in value.
Is Dollar-Cost Averaging a Good Strategy for You?
Understanding and implementing any investment strategy is based on a number of different factors. Here are some things to consider if you’re thinking of using DCA as an investment strategy.
- If you’re new to investing and want to minimize the emotional aspects of investing, want to take a more passive approach and want to start investing with small sums of money, DCA may be the right place to start.
- If you want to be actively involved in your investments – trading stocks on a regular basis, purchasing different types of securities, and have a large sum of money to invest, DCA may be too passive for you.
- Dollar-Cost Averaging can be used as a single investment strategy on its own. However, it doesn’t mean that you can’t have other investment strategies to complete your overall investment portfolio. For example, you could use a DCA strategy for your 401k and IRA accounts, but use another strategy, such as a dividend investment strategy for purchasing stocks.
Be sure to check out my eBook Simple Investing, to learn more about the basics and start investing today.
Do you dollar-cost average your investments? Comment below.