Definition
Dollar-cost averaging (DCA) is an investment strategy that helps in minimizing the impact of volatility on the performance of a financial asset or instrument. Under this strategy, the investment is spread out through smaller sums invested at regular intervals until the total capital is exhausted.Since financial instruments may come with the risk of volatility, DCA helps in minimizing this risk by aiming to lower the average cost of investing.
Example
Suppose one invests in stocks of a company that are currently available at $10.00 per share.Instead of buying them in a single purchase, one can buy 10 shares now and the same quantity in the near future.As soon as the stock price declines to $8.00 in the near future, one can purchase 10 more shares.Thus, the net investment value will be= (10 * 10) + (8 * 10) = 180This helps in reducing the average share price paid for 20 shares is = 180 / 20 = $9
Why it matters
Dollar-cost averaging has three key benefits:1. It helps to avoid the impact of timing an investment.2. It takes away the emotion from investing.3. It enhances longer-term gains.Simply put, dollar-cost averaging can save investors from common psychological biases that are driven by fear and greed. As markets tend to go up in the long run, dollar-cost averaging can help investors in recognizing that short-term volatility should not drive the course of action when it comes to investments.