What is dollar-cost averaging (DCA)?

What is dollar-cost averaging, how does it work, and how can investors use it to maximise their investment returns over time?

wooden block letters spelling DCA
Image source: Getty Images

What is dollar-cost averaging (DCA)?

If you’re struggling to understand the complexities of investing and want an uncomplicated investment system, look no further than dollar-cost averaging (DCA). It involves investing on a consistent basis with profitable returns over time, despite market fluctuations.

In this article, you’ll learn how to invest like a pro and grow your wealth over time, without having to anxiously analyse the market every day. You’ll also learn the potential benefits behind dollar-cost averaging, examples of how it is used, and how you can apply this powerful method of investing.

Understanding dollar-cost averaging: How it works

Dollar-cost averaging is a popular strategy among investors who want simplicity when it comes to investing over the long term. It’s suited to investors with lower risk tolerance and mainly geared towards the ‘set and forget’ investing mindset.

So, let’s look at how dollar-cost averaging works in a comparison of two investors.

Say investor 1 has $5,000 and invests everything in one go.

Month 1

  • Investment: $5,000 
  • Share price: $10 
  • Units purchased: 500

This investor now has 500 units invested. 

Now, let’s look at an investor who utilises dollar-cost averaging and invests $1,000 consistently over 5 months, rather than a single upfront lump sum.

Month 1

  • Investment: $1,000 
  • Share price: $10 
  • Units purchased: 100

Month 2

  • Investment: $1,000 
  • Share price: $11
  • Units purchased: 90

Month 3

  • Investment: $1,000 
  • Share price: $9.25
  • Units purchased: 108

Month 4

  • Investment: $1,000 
  • Share price: $7.50
  • Units purchased: 133

Month 5

  • Investment: $1,000 
  • Share price: $8
  • Units purchased: 125

As you can see, investor 1 invests $5,000 in month 1, and that investor has only 500 units.

However, investor 2 has invested $1,000 each month over a 5-month period and has 556 units in the end. That’s 10% more units than investor 1. Amazing!

This is the power of dollar-cost averaging.

Of course, the market fluctuates due to many factors such as interest rates, government changes, commodity supply and demand, news updates, and ‘black swan’ events like a global pandemic. With all these changes, the market goes up and down but evens itself out over time.

If you are working, you are likely already dollar-cost averaging through your superannuation fund. Your employer would be depositing super payments directly into your fund at regular intervals, and your fund would use this money to buy more shares or other assets, such as bonds, on your behalf. This means your regular contributions are being invested whatever state the market is in. As a result, the more contributions you make on a regular basis, the more wealth you grow.  

Your super fund is most likely investing in a well-diversified portfolio but it is always worth checking out exactly how your fund is investing your money.

So, look at your account and read about the strategy that your fund has chosen for your investments (such as balanced or growth). Some funds will allow you to change strategies in accordance with your risk tolerance, so give them a call to discuss your options.

And while we’re on the subject, it’s also worth ensuring that your super fund itself has a good track record for delivering strong, reliable returns. You can use the new government MySuper comparison tool on the Australian Taxation Office website to compare the performance of all the basic MySuper funds.

If you’re in a different type of fund, simply use Google to research how your fund’s historical performance compares to all the other funds out there. You may be surprised – even astounded – at the difference between them. 

Benefits of dollar-cost averaging 

There are many benefits of dollar-cost averaging, so let’s take a closer look at each one below.

There’s no need to time the markets

Waiting for the market to reach a certain price point is like waiting for Donald Trump to release his tax returns – it ain’t gonna happen. However, when you invest every month, despite what the share price is, you’re often going to be able to purchase lower-priced shares and reap the benefits in the future.

Focus

Analysing the markets, studying trends, and reading financial reports can be a full-time job. Most casual investors don’t necessarily have time for that. If you have a job or business, you likely won’t have that extra time to read up on your investments before making a purchase.

With dollar-cost averaging, you simply invest at regular intervals, regardless of the share price. This means you can focus more on your job or business, which is producing the income you need to invest back into your portfolio.

Easy to apply

It’s very easy to apply dollar-cost averaging. All you have to do is simply click the buy button and you’re off to the races. There’s no financial complexity behind it – just remind yourself to make the investment every month and you’re done!

The bottom line

Dollar-cost averaging is attractive for beginner investors, as the barrier to entry is low. Additionally, you don’t need any specialised knowledge or an understanding of complex financial instruments, nor do you need to spend hours of time on market analysis to get started.

All you need is the commitment and discipline to stick to this method long term.

Although dollar-cost averaging doesn’t guarantee a profit in the short term, it does force you to make regular investments to create greater wealth. You will soon see its effect in evening out market fluctuations over time, and this will enable you to steadily grow your portfolio.

Last updated 7 March 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.