Dollar-Cost Averaging: A Better Way to Invest?

Dollar-cost averaging can be a good strategy for “ordinary” investors with small amounts of money who want to build wealth over time.

One of the biggest money misconceptions is that you need a big chunk of capital to start investing. I remember back in the day when my parents told me I needed at least $5,000 to buy into a mutual fund. Those days are long gone.

Today, most people can start investing with a few bucks. In fact, with the help of dollar-cost averaging, you can consistently invest even if you don't think you can afford to.

What is Dollar-Cost Averaging?

Dollar-cost averaging (DCA) is an investment strategy that focuses on regularly investing the same amount of money. You might invest $500 once a month or invest $10 a week, depending on your situation and goals.

For example, you might buy $100 worth of Wal-Mart (WMT) stock every month for the next five or twenty years. The idea is to lower the total average cost for the shares purchased over time. More shares are bought when prices are low, and fewer shares are bought when prices are high.

Advantages of Dollar-Cost Averaging

• Ease into investing. You don't need a large amount of capital to begin. This works well for individuals who currently don't have a lot of cash but can set aside a small percentage of their income for investing consistently.
• Reduces your total average cost per share. Because you buy more shares when stock prices are low and fewer when prices are high, your cost per share is likely to average out. Some experts claim this approach effectively reduces your risk during volatile market swings.
• Works well with index investments. When used with indexing, DCA allows easy access to a wide swath of the market. You don't have to pick individual stocks, which can be inefficient when you only have a small amount of money.

Drawbacks of Dollar-Cost Averaging

The number one argument against DCA is that your investment will underperform against the rest of the market when prices are strongly trending up. You can't bet big (and potentially win big) with a DCA approach.

Another argument against DCA is that its benefit is small compared to the lost returns from waiting to invest the money over time. Investing now is always better than investing tomorrow. Your money can be put to work early and productively. However, this only works if you have money and are certain that the instrument you're investing in will yield a positive return.

Investing it all at once might make sense instead of parceling it out if you come into a significant amount of capital. Consider index investments to benefit from instant diversity potentially. But DCA makes investing consistently possible for those without a large amount of money.

Take Advantage of DCA through DRIPs

Investors can use DCA to take advantage of compounding via Dividend Reinvestment Plans (DRIPs). As the name implies, DRIPs reinvest any dividends from shares into more shares. This automatic reinvestment allows you to ramp up your portfolio over time.

For example, you could invest in an ETF that pays a dividend of $0.50 per share each quarter. Let's say you invest $50 monthly in a dividend ETF that costs $15 a share. After three months, you have ten shares. Your dividend at the end of that first quarter is $5.00. Your dividend buys approximately 1/3 of a share.

At the end of the second quarter, you have 20 1/3 shares, and your dividend payout is now $10.17 instead of just $10. But now that reinvested dividend buys 2/3 of a share. After six months of consistent investing, you already have an extra share, bought with dividends. The whole thing snowballs as you keep using the DCA strategy and reinvesting dividends.

Bottom Line on Dollar-Cost Averaging

Even though stock prices change regularly, you don't have to use that as an excuse not to invest. With the help of dollar-cost averaging, you can ignore the day-to-day rollercoaster road and keep steadily building your portfolio. Over time, it's a way to create long-term wealth without needing a large amount of money all at once.