What Is Dollar-Cost Averaging?
Dollar-Cost Averaging is a great tool for any investor to mitigate or reduce the impact of volatility of the asset that they are buying.
Dollar-Cost Averaging (also known as DCA or Constant Dollar Plan) is an investment strategy whereby an investor determines how much they want to invest and then divides that total amount into periodic purchases. By doing so, the investor reduces the their risk as asset prices fluctuate. The asset purchases occur regardless of the price and the purchases are made at regular intervals (like weekly, monthly or quarterly).
For example: If you have $1,200 and want to purchase a specific equity or asset, you can apply dollar-cost averaging by buying $100 worth of the asset each month. After 12 months, you will have purchased $1,200 worth of the asset.
As a result, you don’t need to ‘time the market‘. Nobody can predict if an asset is going to go up or down in value over time. As per the example above, if you invest $1,200 all at once (also known as a ‘lump sum‘), you could be buying at the top or the bottom. By separating it into 12 equal purchases (once per month), you mitigate your purchase risk by splitting the risk out over 12 months.
Another great benefit of a dollar-cost averaging investment strategy is that it’s a ‘forced savings’ or ‘forced investing’ strategy. Instead of calculating the total amount of money you want to invest in an asset, you can instead ‘plan’ to put $50 or $100 or $250 per month into an investment. By doing so, it’s automatic, so you don’t ever have a chance to spend it on frivolous things like doodads you don’t need.
Real World Dollar-Cost Averaging (DCA) Examples
If you’ve ever had a retirement savings or investment plan, chances are you’ve already experienced dollar-cost averaging. DCA is one of the most used investment vehicles to mitigate risk and to force savings.
Some real-world examples of dollar-cost-averaging are 401(k) or Retirement Savings Plan (RSP) contributions that are made on a monthly basis. Likely, you signed a Pre-Authorized Contribution form (also known as a PAC) so that the investments are purchased on a regular (usually monthly) basis. By using DCA for your 401(k) or RRSP accounts, you are spreading out or mitigating your risk in purchasing assets for your long-term investment.
And if your dollar-cost averaging strategy includes rewards or interest paid out regularly (weekly or monthly or quarterly or even yearly), then the combination of DCA and compounding interest will turbocharge your return on investment! It is this strategy (DCA and compounding interest) that you want.
Deep Dive into DCA Numbers
As always, we look ‘behind the curtains’ to calculate specific numbers in order to make comparisons. Here are 2 examples using consistent dollar-cost averaging investing for 25 years.
For example: investing $50 or $200 per week, every week for 25 years. Here are the return on investments after each year for 25 years assuming that reward rates do not change. A 100% ROI means that your investment has doubled in value. A 200% ROI means that your investment has tripled in value.
|End of Year||Weekly DCA ROI|
|Weekly DCA ROI|
|Weekly DCA ROI|
Please note: If you are investing the same amount weekly, monthly or quarterly, your return on investment (ROI) remains the same regardless of how much you are investing.
For example: Whether you are investing $50/week or $200/week for the same amount of years, your ROI remains the same.
What Happens if You Don’t Dollar-Cost Average (DCA)?
If you want to invest an initial amount, earn weekly rewards and forget about it, you aren’t using the dollar-cost averaging investment strategy. However, this is not to say that you’re missing out on rewards!
If you put a specific amount of money into an asset and you earn weekly rewards, you benefit from compound interest. Each time you earn rewards, those same rewards are added to your ‘principal’ every week, and those in turn earn rewards. This is called ‘compounding‘.
Here are some numbers:
|End of Year||ROI using|