Dollar Cost Averaging
You’ve probably heard of Dollar Cost Averaging (DCA) over the years, but maybe you don’t know exactly what it is. Believe it or not, DCA has been around a long time and I’ve often found it to be a little misunderstood. Therefore, I wanted to take a moment to review DCA–what is it? And, why people do it in the first place?
The bottom line is, DCA is a way of investing ones money. Only, instead of investing all your money at once, you do it through equal increments over a designated period of time.
Example: An individual receives a $120,000 bonus (after taxes). They could certainly take that money and invest it into the markets right away. But with DCA, they would invest a portion over a certain period of time–let’s say $10,000/mo for a year.
Why would anyone invest their money in monthly installments over all at once? Essentially it’s a way to lessen the risk of your investment. It gives you a way to get the average price of the markets (or stock) over a given period of time.
Example: Let’s assume Berkshire Hathaway stock is trading at $120,000 per share today and you go to purchase it. In this case, you’d own one share. However, if you dollar cost averaged over 12 months and the stock dipped to $60,000 a share for half the months, then you would own greater than one share over that same time period.
Of course it can work in reverse, so it isn’t always the best way to maximize your return. That said, it’s generally used as a way to minimize downside risk as you are purchasing smaller increments over time.
How to decide
There is no obvious answer when to, or not to, use this strategy. I would look at the following points to help guide your decision:
- How risk adverse are you?
- What percentage of your investments will this purchase represent?
- How much money is being invested?
- Where we are in a market cycle?
If you decide to DCA, the next decision is over what period of time. I can tell you I rarely see people do over a 12 month period. (Those times that I have, it was with an extremely high value of money or with a very conservative client.)
Most people do some form of DCA in their daily lives, as this is usually how we are able to invest. Our 401(k)’s and monthly investment accounts get invested this way.
However, I’ve found the majority opt to not DCA, as they believe in the markets and the fact that approximately 75% of the year the market is up. But, DCA can be a great tool for some and can serve as a great way to divest out of a concentrated stock position (such as company stock).
As always, if you have any questions as to whether this is the right thing for you, don’t hesitate to reach out and ask.