Dollar cost averaging is a simple strategy for buying mutual funds. However, it may sound complex at first. Dollar cost average, or DCA, involves buying the same dollar amount of an investment at regular intervals. In doing so, the investor will purchase more shares of the investment when the price is low and fewer shares of the investment when the price is higher. This strategy results in automatically buying low and selling high without the need for complex research.
In order to understand dollar cost averaging, an example often is most instructive.
Assume an investor wishes to invest $500 per month into an investment. For our example, we’ll call the investment XYZ Mutual Fund. When the investor begins investing, XYZ Mutual Fund is trading at $20 per share. In order to dollar cost average into the mutual fund, the investor will invest the same amount, $500, each month.
The first month, the investor purchases $500 worth of XYZ Mutual Fund, or 25 shares. (For our example, we will assume there are no loads or transaction fees for investing into the mutual fund, although the results would accomplish the same thing if there were.)
The following month, the price of XYZ Mutual Fund has fallen to $16 per share. The investor still invests $500, but this results in the investor purchasing 31 ¼ shares instead of the original 25 shares.
The next month, the mutual fund price has risen to $25 per share. Now the same $500 investment yields just 20 shares for the same amount of money.
Over these three months, the investor has acquired 76 ¼ shares at an average price of 19.67 per share. If the investor had purchased all $1500 worth of shares at the beginning, the average share price would have been much higher.
Over longer periods of time, dollar cost averaging tends to provide the investor with less volatile returns and greater profits than trying to market time larger one-time investments into mutual funds or other investments.
Dollar cost averaging does not guarantee profits and is a long-term investment strategy suitable for investors with a time horizon of several years.
There are many ways to dollar cost average into mutual funds. Many fund families offer monthly ACH investments that automatically invest money from the client's checking account.