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Dollar Cost Averaging: What Is It and How Does It Work?

01 July 2023

If you are looking for a simple and effective way to invest your money, you may have heard of dollar cost averaging. But what is it exactly and how does it work? Learn the basics of dollar cost averaging, its benefits and drawbacks, and some tips on how to use it.

What Is Dollar Cost Averaging?

Dollar cost averaging (DCA) is an investment strategy that aims to apply value investing principles to regular investment. The term was first coined by Benjamin Graham in his book The Intelligent Investor.

Dollar cost averaging involves investing the same amount of money in a target security at regular intervals over a certain period of time, regardless of price. By using dollar cost averaging, investors may lower their average cost per share and reduce the impact of price volatility on their portfolios. In effect, this strategy eliminates the effort required to attempt to time the market to buy at the best prices.

How Does Dollar Cost Averaging Work?

Dollar cost averaging works by buying more mutual fund units when prices are low and fewer units when prices are high. This way, you avoid paying too much for your investments and benefit from the long-term growth of the market.

For example, say you plan to invest $1,200 in Mutual Fund A this year. You have two choices: You can invest all of your money at once at the beginning or the end of the year—or you can invest $100 each month.

While it might not seem like choosing one approach or the other would make much of a difference, if you spread out your purchases in $100 monthly portions over 12 months, you may end up with more shares than you would if you bought everything at once.

Consider this hypothetical 12-month result:

Month
Share Price
Number of Units Purchased
April $9 11.11
May $10 10
June $7 14.29
July $9 11.11
August $11 9.09
September $9 11.11
October $10 10
November $9 11.11
December $10 10

 

In the example above, you would end up saving 42 cents a share by spreading out your investments over 12 months instead of investing all of your money one time.

If you bought $1,200 worth of Mutual Fund A at a price of $10 per share in January or December, you would own 120 shares.

If you bought $100 worth of Mutual Fund A a month for 12 months, your average price per share would be $9.58, and you would own 125.24 shares.

In this example, dollar cost averaging buys you more shares at a lower price per share. When Mutual Fund A increases in value over the long term, you’ll benefit from owning more shares.

What Are the Advantages of Dollar Cost Averaging?

Dollar cost averaging has several advantages for investors, such as:
  • It can reduce the risk of buying at the wrong time and losing money due to market fluctuations.
  • It can lower the average cost per share and increases the potential return on investment.
  • It encourages disciplined and consistent saving and investing habits.
  • It simplifies the decision-making process and reduces emotional stress.
  • It works well with any type of security that has price variations, ETFs or mutual funds.

What Are the Disadvantages of Dollar Cost Averaging?

Dollar cost averaging also has some drawbacks that investors should be aware of, such as:
  • It does not guarantee a profit or protect against a loss in a declining market.
  • It may result in missing out on opportunities to buy at lower prices or sell at higher prices if the market trends strongly in one direction.
  • It may incur higher transaction costs and fees due to frequent trading, this is the case with our ETF’s, there are no trading fees for mutual funds.
  • It may not be optimal for investors who have a large lump sum to invest or who have a short-term investment horizon.

How to Use Dollar Cost Averaging Effectively?

If you want to use dollar cost averaging as part of your investment strategy, here are some tips to follow:
  • With the assistance of a advisor choose a mutual fund that suits your risk tolerance, investment goals, and time horizon.
  • Decide how much money you want to invest and how often you want to invest it.
  • Set up a regular schedule and stick to it, regardless of market conditions.
  • Review your portfolio periodically and adjust your strategy if needed.
  • Consider using a tax-advantaged account, such as a RRSP or TFSA
Dollar cost averaging is a simple and effective way to invest your money over time. It can help you lower your average cost per share, reduce the impact of price volatility, and build wealth in the long run. However, it also has some limitations and risks that you should be aware of. Therefore, you should always do your research, diversify your portfolio, and consult your Wealthforce professional before making any investment decisions.
Cindy C. - Financial Blogger

Cindy C.