Why using Dollar-Cost Averaging for buying stocks makes sense
Most people with even a slight interest in finance will probably have heard of the term dollar-cost averaging. This article gives you the basics on what is meant by the term, how it works, and why it is so useful. It is a simple concept to understand, and even easier to apply, and can be really helpful for newbies as they start out on their investment journey.
What exactly is dollar-cost averaging?
Dollar-Cost Averaging (DCA) is a method of purchasing a financial product or investment: usually a stock, mutual fund, or some other kind of financial vehicle or entity that is listed.
The process involves allocating a set sum of dollars into the stock or other financial instrument, at fixed regular intervals. By investing a fixed amount each time, more shares are purchased when the price is low, and less shares when the price is higher, resulting in an overall lower average cost.
One of the most important advantages of DCA is that it removes the element of market timing because the operation is automatic. This means that it reduces the risk of investing a large amount in a financial asset when it is overpriced. As a bonus, it helps to instil the discipline of investing on a regular schedule.
How does it work?
The best way to see how DCA works, is by using an example:
Ivan plans to invest in shares of Company A. He has done his research on the company's fundamentals, he thinks the stock looks undervalued right now, and he believes it will make a good long term investment. He decides to apply the DCA method and will set aside $300 a month to buy the shares over a period of 1 year.
Share price at start of each month
Number of shares bought
Average price = $2.35
Total Shares = 1452
Why dollar-cost-averaging is so beneficial
At the end of Year 1, Ivan would have spent a total of $3,600 to buy 1,452 shares of Company A, at an average price of $2.35. If he had instead bought the same quantity of shares at the start of the month in December, at $2.75, he would have spent $3,993 in total, or $393 more.
Obviously without using DCA, he would not only have had to spend a greater sum of money (which he could have saved), but the higher price that he paid for the shares in December would also affect the profitability of the shares. If in the following month, prices of Company A's shares are trading at $3.00, he would have made $580.80 in profit if he had chosen the DCA method of investing. Without DCA, he would have made only $363 dollars, a significantly lower amount of profit.
Clearly using the DCA method for buying stocks makes a lot of sense. However, that does not mean that your investments will perform well as a result! Prior to any investment in a financial product, you always have to do your due diligence homework, and that includes reading all the fine print.