Dollar Cost Averaging (DCA) is a technique or formula for purchasing shares of an investment in equal dollar amounts over time. In doing so the investor will at times purchase shares when the market is going up and at other times when the market is down. Over time the investor benefits because their average cost per share will be lower than if they had purchased the shares using other methods.
For our Dollar Cost Averaging example we will replace the idea of purchasing stocks with that of a New England staple: Lobster. Lobster can be caught year round but depending on the season the prices can vary dramatically.
Last year Lobster prices averaged:
Our diner starts on January 1 with a $1000 lobster budget, but they don’t know what the future price of lobster is going to be. They might reason that the price in the 1st quarter is very good and they spend a $1,000 of their allotted budget for lobster (that’s 166 pounds of lobster). However, when the prices steadily increased during the 2nd quarter our diner may panic and spend the remaining $3,000 on lobster at that time because there would be no telling where the prices would go (this would be 300 pounds of lobster). What if the prices continued to go up, wouldn’t it be best to buy as much as possible in the 2nd quarter? Again, our diner would not have known the prices would drop so it would be perfectly reasonable for our diner to spend all their money in the 2nd quarter.
In the above Dollar Cost Averaging example our diner would have been able to buy a total of 466 pounds of lobster. Let’s try this again but this time our diner is very calm and evenly spaces their purchases so they buy $1,000 of lobster each quarter. If we do the math, our diner will eat 641 pounds of lobster which is a lot more. The problem with trying to “time the market” or “time when to buy lobster” is that we don’t know what the prices are going to be in the future. The dollar cost averaging technique removes emotion and will often help the investor buy more of their investment.
This investment technique is often used in retirement planning in such accounts as 401(k)s, Roth IRAs and others. Dollar-Cost Averaging does not assure a profit or protect against loss in declining markets. Such a plan involves continuous investments in securities regardless of fluctuating price levels and the investor should consider his/her financial ability to continue purchases through periods of low levels.