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Explaining the Dollar-Cost Averaging Strategy

The dollar-cost averaging strategy makes it possible to invest in assets less and minimize the risk of loss at the same time. In other words, you have a chance to lower the amount of capital invested in the selection of underlying assets over a specific period, usually, one year. The idea of dollar-cost averaging is to buy smaller amounts of assets using regular intervals despite the price instead of buying shares at a given value.

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In this article, we will try to figure out if the strategy works based on a dollar-cost averaging example. The main mission is to check if it really helps to lower investment costs and increase returns in the long run.

How Dollar-Cost Averaging Strategy Works

The strategy works best when investing in stocks, mutual funds, or ETFs. While some investors generally use a single security to invest at a particular time, the concept of dollar-cost averaging assumes that you divide your capital into several equal parts and use it gradually while purchasing smaller quantities of securities at preset intervals regardless of their value. The approach is supposed to minimize the risk of overpaying before the price drops.

The methodology is based on the idea that the price never moves in a single direction. With a bigger number of securities bought over a certain time, you can reduce the risk of paying over the average price in the long run due to multiple purchases. Furthermore, with a dollar-cost averaging strategy you can keep your capital working on a considerable basis, which is a key factor of successful long-term investing.

The strategy has become extremely popular with 401(k) concept followers. The methodology works great in case you already have a retirement plan. If you do, you might be using a dollar-cost averaging strategy without even knowing.

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Dollar-Cost Averaging Example

As we have already explained, when performing the strategy, you need to put all emotions aside, create a purchasing plan, and regularly buy the same (small) amount of assets as per schedule regardless of their price. Ideally, it will lead to more purchases when the stock value goes down, and fewer securities, when the price rises.

Let’s say, you have intention to invest $1,200 in the underlying mutual fund the next year. You have two major options:

  1. The first one is to invest all your capital right at once in the beginning of the following year.
  2. The second one is to spend $100 every month purchasing a smaller volume of targeted instruments.

The second option lets you spread all your capital across 12 equal portions. As a result, you may end up the next year with a bigger number of assets if compared to the first method when you buy all assets at a time investing the entire capital.

Who Can Benefit from the Dollar-Cost Averaging Strategy?

The approach can seem like a good idea in case you:

  • Only start the investing career and do not have big enough capital to invest.
  • Do not want to do market research or maintain technical analysis.
  • Want to create an effective retirement plan via IRA or 401(k) accounts.
  • Do not want to keep all your investments in the down market.

If you apply to any of the following, you will probably do not want to use the dollar-cost averaging method:

  • You have a huge investment capital.
  • You target mutual funds with higher initial or entering minimum.
  • You like doing market research and enjoy the technical part of trading.
  • You are a day trader.

The Bottom Line

From the practical point of view, a dollar-cost averaging strategy gives a chance to start investing with a smaller capital. It is a perfect solution for those who do not have much money to invest right at once. Besides, it makes it easier to maintain your assets during market dips, which can be intimidating, especially for beginners. However, it will not be profitable in case you decide to exit with all investments during the down market.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.