Guide to the Dollar Cost Averaging Formula
Dollar-cost averaging is a strategy value investors use to invest equal dollar amounts at different intervals. This strategy means that you don’t have to guess what the market is going to do – you’re just investing the same amount at the same time each month.
Keep reading to discover how to apply the dollar cost averaging formula and how you can use it when investing.
- Dollar-cost averaging (DCA) means that you regularly invest the same amount of money (e.g., $100) over time in stocks, mutual funds, or ETFs, no matter what the price is.
- The dollar cost averaging formula is Average Price Paid Per Share = Amount Invested / Number of Shares Owned
- Dollar-cost averaging is investing money in regular amounts over time. A lump sum means that you invest the entirety of the amount in one single payment.
- Value averaging (VA) is very similar to dollar cost averaging. You still invest at regular intervals. But instead of contributing the same amount each month, you set a target growth rate that dictates your investment amounts.
- Use our free dollar cost averaging calculator and download it to Excel to simplify the dollar cost averaging calculation process.
- Dollar-cost averaging is an excellent strategy if you have a low-risk tolerance, want to avoid timing the market, and it helps you become a disciplined investor.
- Its drawbacks are missing lower prices, becoming too passive with your investments, and running into high transaction costs.
What is dollar cost averaging (DCA)?
Dollar-cost averaging (DCA) means that you regularly invest the same amount of money (e.g., $100) over time in stocks, mutual funds, or ETFs, no matter what the price is. It’s a strategy that helps you reduce risk and pay less for investments.
Instead of purchasing stocks at a single price point, your money purchases more shares when prices are down and less when prices are up. It takes the guesswork out of investing decisions.
Here’s an example:
You want to invest $2,000 in value companies like Johnson & Johnson (JNJ) and Target (TGT). Rather than trying to time the market and guessing when the price will be lowest, you simply invest $500 per week into these companies over four weeks.
When you dollar cost average, you automatically purchase fewer shares when stock prices are high. You also automatically purchase more shares when the stock prices are low. What you purchase “averages” out.
With this strategy, you’re not timing the market or trying to predict the market’s future price movements (a risky strategy for long-term investing).
The most important rule with dollar cost averaging? Be consistent. Maybe you’re paid bi-weekly. You have $250 leftover after every paycheck to invest ($500 at the end of each month). With dollar cost averaging, you could set up bi-weekly automatic deposits of $250 to invest in your portfolio.
Automating this process ensures you stick to your strategy and you regularly invest.
Dollar-cost averaging formula
The simple version of DCA involves two elements:
- A regular investment amount
- When you regularly invest that amount
So say that you have $2,400 to invest over a 3-month period. You don’t spend all this money at once. Instead, divide $2,400 by three. You’d invest $800 per month or $200 per week.
But if you want to know the exact average price you’re paying per share on a monthly basis, you’d use the following formula:
Average Price Paid Per Share = Amount Invested / Number of Shares Owned
Maybe you’re investing in XYZ Company. The shares are currently trading at $12.00 per share. Since you have $200 to invest, you could buy 16.7 shares per week at a $12.00 share price ($200 / $12).
The next week, the share price drops to $10.00. Even though the price has dropped, you still invest $200, purchasing 20 shares. You stick with your strategy. The same thing happens next week. The share price drops to $9, which means you purchase 22.2 shares for $200. The share price remains stable next week.
To determine the average price paid per share, you’d first calculate the total value of the shares:
Total Value of Shares = ($12 * 16.7) + ($10 * 20) + ($9 * 22.2) + ($9 * 22.2) = $800
You now own 81.1 shares. Divide the total value of shares by the number of shares owned.
Average Price Paid Per Share = $800 / 81.1 = $9.86
If you had invested the whole amount at the start of the investment, your cost would have been $12 per share. As you can see, you pay less overall ($9.86) for the shares by using the dollar cost averaging method.
Dollar-cost averaging vs lump sum investing
Dollar-cost averaging is investing money in regular amounts over time. It’s the opposite of lump sum investing. A lump sum means that you invest the entirety of the amount in one single payment.
DCA spreads out the risk of your investments. A lump sum means you might get better share prices depending on market movements or you might not. DCA is a better strategy if you’re worried about investing a huge sum of money at once and the market suddenly takes a downturn.
Dollar-cost averaging vs value averaging
Often confused to be the same thing, value averaging (VA) is very similar to dollar cost averaging. You still invest at regular intervals.
However, instead of contributing the same amount each month, you set a target growth rate. You then adjust the next month’s contribution based on how much you made or lost to achieve your target growth rate. Basically, you invest more when the share price falls and less when the share price rises.
The problem with value averaging is that it’s complicated. Also, you could actually run out of money in a downturned market, hindering your ability to make larger investments to hit your target growth rate.
Dollar-cost averaging calculator Excel
The formula we shared is a simplified example of the dollar cost averaging formula. It can get more complex if you’ve got a lot of investments and shares.
A dollar cost averaging calculator in Excel can help simplify the process. Download our free dollar cost averaging calculator. Track and view your investments in the spreadsheet and see exactly how much you’re paying per share on average. Also, track any profit made from using the DCA method.
Here’s how to use the spreadsheet:
- Invest at the same time every month and record the time period (Column A).
- Add the company you’re investing in (Column B) and the monthly investment amount (Column C).
- As you invest each month, keep track of the share price (Column D).
- In the “Lump Sum Comparison” section, compare what you would have paid for shares if you had invested your money all at once.
- In E20, subtract your DCA’s “Total Shares Purchased” (E17) from the Lump Sum’s “Shares Purchased” (K6).
- In E21, multiply “Average Share Price” (E19) by “Additional Shares Purchased Using DCA” (E20) to view the profit you made using the DCA method over time.
Example of dollar cost averaging
Let’s complete two exercises to see the dollar cost averaging formula in action in comparison with the lump sum strategy.
Example #1: Dollar Cost Averaging
You have $750 to invest over three months ($250 per month). After researching a specific company, you decide to invest in its shares that are trading at $25 per share. That means you can purchase ten shares for $250 that month.
Now let’s say the price increases to $50 per share the next month. You can purchase five shares instead of ten this month with your $250. In the third month, prices drop to $10 per share. You can buy 25 shares.
Over these three months, you invest $750 and have 40 shares. Calculate your average cost per share: $750 / 40 = $18.75.
Although we recommend holding your investments for the long-term, say that you sell your shares during Month 4 at $25 per share or the same price as Month 1. 40 shares x $25 = $1,000. That’s a profit of $250 ($1,000-$750).
But maybe the price jumps back to $50 per share during Month 4. In this case, 40 shares x $50 = $2,000. That’s a profit of $1,250 ($2,000-$750).
Example #2: Lump Sum Investing
Now say you went with the lump sum strategy. You invested $750 that first month at $25 per share. You’d have 30 shares instead of the 40 shares ($750 / $25) that you would have had with dollar cost averaging. Your average cost per share is also higher ($25 vs. $18.75).
If you sold your shares during Month 4 at a $25 share price, you’d sell 30 shares for $750. You would not have made a profit. Instead, you’d break even.
But maybe you sold your shares during Month 4 at a $50 share price. 30 shares x $50 = $1,500. You’d have made a profit but that’s $500 less than what you could have made if you had followed dollar cost averaging.
Pros of dollar cost averaging
Dollar-cost averaging is typically an excellent strategy when the market is struggling. It means you don’t worry about timing the market. It also removes emotions from the investing process and ensures you invest regularly.
NO TIMING THE MARKET
No one can predict the future. That’s what makes market timing so risky. For example, say that you invest $2,000 all at once. Suddenly, the market experiences a major downturn. You lose a lot of money.
You don’t when the market is going to bottom out. Dollar-cost averaging averages out market dips and jumps.
AUTOMATION REMOVES EMOTION
DCA means that your investments are automatic: you invest automatically at regular intervals over the long term, rather than trying to guess the best time to purchase shares.
Your investment decisions aren’t based on emotions. It’s more mechanical. You then avoid panic buying or selling as prices swing.
With DCA, you become a disciplined investor. You invest regularly, growing your portfolio balance over time without having to think about it. This helps generate more wealth in the future.
Cons of dollar cost averaging
Dollar-cost averaging isn’t perfect. It’s not guaranteed to protect you from losses. Its passive approach also doesn’t mean that you should just blindly invest. Research is required for companies and transaction fees.
MISSING LOWER PRICES
Following DCA means that you could miss out on buying more shares when prices are low.
For example, say that, because of your DCA strategy, you miss out on buying shares on a date when the price is the lowest. The price keeps going up from there. As market prices do tend to rise over time, you could have made more by investing a lump sum instead of investing in small increments.
BECOMING TOO PASSIVE
Another DCA drawback is that it’s very passive. It doesn’t help you identify solid value investments, so make sure you do your research before blindly investing. We recommend completing a fundamental analysis for any value company you’re considering as an investment.
Too, don’t get complacent. Check up on your investments and any market changes at least every two to three months to determine if you need to adjust your strategy.
EXPERIENCING HIGHER TRANSACTION COSTS
Purchasing shares in small amounts can incur high transaction costs from your brokerage company, hurting any gains in your portfolio. This is why we highly recommend researching any brokerage platform to avoid high fees.
Hint: We recommend M1 Finance, a platform with low trading fees.
Get started with dollar cost averaging
Consider dollar cost averaging if you’re a new investor and have a set amount you want to start investing. Here are other reasons that suggest dollar cost averaging might be for you:
- Reduce the downside risk that comes with investing in a lump sum.
- Avoid the stress and worry of trying to time the market.
- Lower the average price you pay for shares through the market’s natural volatility.
Did you enjoy this guide to dollar cost averaging? Learn even more about this strategy when you sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor, step-by-step. Check out the course here.