Dollar-cost averaging (DCA) is an investment strategy in which an investor divides the total amount to be invested across periodic purchases of a target security, reducing the impact of market volatility.
How it works: - Invest a fixed dollar amount (e.g., $500/month) on a regular schedule, regardless of price. - When prices are low, the fixed amount buys more shares. - When prices are high, the fixed amount buys fewer shares. - Over time, the average cost per share is typically lower than the average price over the same period.
Example:
| Month | Share Price | Shares Purchased ($500/month) | |---|---|---| | Jan | $25 | 20 | | Feb | $20 | 25 | | Mar | $50 | 10 | | Apr | $25 | 20 | | Total | Avg price = $30 | 75 shares @ avg cost $26.67 |
Average price = $30; average cost = $26.67 — DCA results in a lower average cost than the average price.
Benefits: - Eliminates the need to time the market. - Reduces emotional investing (no panic buying or selling). - Particularly effective in volatile or declining markets.
Limitations: - In a steadily rising market, lump-sum investing often outperforms DCA (you'd buy more shares earlier at lower prices). - Doesn't prevent losses in a sustained bear market.
> Exam tip: DCA is a passive, systematic investment approach. The average cost per share is always less than or equal to the average price per share. 401(k) payroll contributions are a common real-world example of DCA.