History has shown that investing is a proven way to grow long-term wealth. It also entails some risk because markets don’t move higher in a straight line indefinitely. Over time, investors will encounter periods of weak performance. While you can’t completely eliminate investment risk, dollar-cost averaging (DCA) is one approach that helps manage your overall risk when markets decline.

What’s dollar-cost averaging?

DCA is a strategy where you invest a predetermined amount of money in a given security – such as a mutual fund or an individual stock – on a regular basis. The hypothetical example below allows you to see this strategy in action.

Let’s say you decide to invest $1,000 per month in XYZ mutual fund. Over the course of a year, the markets experience a few swings in performance, so your purchase price and the number of units you receive each month will reflect those market movements:

Through the DCA method, your average purchase price during the 12 months is $8.61 (all figures rounded to two decimal places), while your total $12,000 investment results in 1,401.41 units of XYZ Fund received. Notice how you bought fewer units when the fund price was higher (especially January to April), and bought more units when the price dipped notably (such as August to October). After 12 months, the value of your mutual fund investment is $12,318.39 (i.e., $8.79 x 1,401.41).

Now consider the “lump sum” method where you invest the entire $12,000 at the beginning of the year. In our example, your purchase price was $9.18 and you received 1,307.19 units of XYZ Fund. After 12 months, the value of your mutual fund investment is $11,490.20 (i.e., $8.79 x 1,307.19).

Typical benefits of DCA

Of course, this hypothetical example is just one of many possible scenarios, but it illustrates how a DCA strategy helps avoid the temptation of timing the market. It’s near impossible to predict exactly when the market will rise or decline, so DCA allows you to invest steadily over time and ignore short-term market fluctuations. As well, purchasing more units when prices are low and fewer when prices are high should help “smooth out” the performance of your investment portfolio and lower its overall volatility. However, be aware that just as DCA may help reduce the severity of losses, it may also reduce the size of gains when performance is strong.

For people who don’t have a large lump sum available for investing, DCA allows them to get started sooner. It’s much easier to invest small sums regularly, and DCA helps encourage an investing discipline that’s designed to serve you well over the longer term. Many people’s attempts to build wealth get derailed because they lack discipline and end up investing with emotion instead of reason.

Combining DCA and PAC

If you’re interested in dollar-cost averaging as a systematic way to invest, it tends to work well when paired with pre-authorized contributions (PAC). By using PACs, a set amount of money is automatically withdrawn from your bank account each designated period (monthly, quarterly, etc.) and can be allocated to your chosen investment as part of a DCA strategy. Many investors like using PACs because they’re convenient and conducive to a consistent investment approach that aims to build wealth methodically.

Want to learn more about DCA or start employing this strategy for your own investment portfolio? Contact an Alterna Advisor today and also discover how easy it is to arrange a PAC for investing.