What is Dollar Cost Averaging?
Before you start investing, you should consider what your investment strategy will be. There are plenty of strategies to choose from, and dollar cost averaging is but one example of a strategy that looks to minimise risk.
- Dollar cost averaging (DCA) minimises the risk by building your position in a stock over time.
- DCA investing requires equal amounts at regular intervals.
- Like all strategies, there are times it works better than others. you should consider your own financial situation before making any investment.
Buying stocks can be stressful, particularly if you are trying to time the market. Buy too soon and you risk regret when the price drops. But if you wait and the price goes up, you'll feel like you missed out. If your investing strategy is to buy the same amount of stocks regularly then congratulations, you are already dollar cost averaging. If you're not, then let us tell you how a DCA strategy works.
What is dollar cost averaging?
Dollar cost averaging is also known as the constant dollar plan. This is because it's the practice of systematically investing equal amounts of money at regular intervals, regardless of the stock prices. This can reduce the overall impact of price volatility and lower the average purchase price per share.
The aim of a dollar cost averaging strategy is to prevent a poorly timed lump sum payment at a potentially higher price. It also eliminates the effort required to attempt to time the market to buy at the best prices.
How dollar cost averaging works?
Dollar cost averaging is a simple tool to build savings and wealth over the long term by making regular investments. By investing in smaller set amounts over a certain time period, you'll buy both when prices are low and high. This smooths out your average price.
It can be especially powerful in recessions and bear markets. Committing to a dollar cost averaging strategy means that you will be investing when the market or a stock is down, and that's when you can score the best deal and lower your average price.
Recommended reading: What is value investing?
Example of the dollar cost averaging strategy
A prime example of long-term dollar cost averaging is a workplace retirement plan. This is where employees invest regularly regardless of the price of the investment.
Employees can choose the amount they wish to contribute as well as the strategy behind their plan. But of course, it can be used outside of that, particularly if as an investor you want to avoid market volatility.
Advantages of dollar cost averaging
Dollar cost averaging helps to remove some of the emotional stress that comes with investing. You avoid making lump sum investments and don't need to follow the fluctuation of stock prices as closely. The focus is not on having to look at the rising or falling market. Instead, you set up a monthly investment at the same time.
Let's take this hypothetical example. Say you buy $2,000 worth of stock over five consecutive months. On the days you buy that stock, the price keeps changing. It starts at $30, then goes to $20, $10, $20 and finishes right back where you started at $30. If you bought the entire $10,000 worth of stock on day one, you would have got 333.33 shares.
But in our example, you end up with 533.32 shares. By using the dollar cost averaging strategy you have ended up with more shares. Now of course it isn't always going to work as if the stock keeps rising then you would get fewer shares. But in this example, dollar cost averaging has reduced the volatility and helped to buy the stock for a lower average price.
Disadvantages of dollar cost averaging
It's true that by dollar cost averaging, you may forgo gains that you otherwise would have earned if you had invested in a lump sum purchase and the stock rises.
However, the success of a lump sum payment relies upon timing the market correctly. Market timing is something that is notoriously hard to do.
Another disadvantage is that over time, markets tend to go up. That means if you invest earlier, it's likely to do better than small amounts invested over a period of time.
It's also not a solution for all investment risks. You still have to identify a good investment and do your own research. If you choose a bad pick, then over time you will just be investing steadily into a losing investment.
A passive approach also means you are not responding to changing environments. So you may want to think about incorporating a way to respond to the markets into any investment strategy.
Which type of investor should use dollar cost averaging?
Dollar cost averaging is a good strategy for investors with lower risk tolerance since putting a lump sum investment into the market all at once can run the risk of buying at a peak. Dollar cost averaging means you can avoid market timing and share price fluctuations. It can also help you to avoid short term volatility in the markets.
Dollar cost averaging FAQs
What is the difference between dollar cost averaging and value averaging?
The difference between dollar cost averaging and value averaging is that when you DCA into a stock, you are investing equal amounts of money at regular intervals, regardless of the price of the stock. When you are using a value averaging strategy, you invest more when the share price falls, and investing less when the share price rises. Instead of investing a set amount each period, a value averaging strategy makes investments based on the total size of the portfolio.
Is DCA investing common in the stock market?
Dollar cost averaging is one of the more popular investment strategies among investors who want simplicity. By investing regularly, investors can gain a better outcome with lower risk tolerance and it is geared towards the 'set and forget' investing mindset. So it is a very popular strategy for those in the stock market who are trying to average out their returns.
How often should you invest when DCA investing?
One of the issues with dollar cost averaging is determining the period over which to use the strategy.
Is it best suited as a near-term investment strategy or long-term?
Well, you should consider your own financial situation before making a decision on how to invest your money. Remember that past performance is no indicator of future performance.
But typically, if you are dispersing a large sum you may want to spread it over one or two years. Any longer and you may result in missing a general upswing in the markets as inflation chips away at the real value of the money.
In addition to purchasing shares at set intervals, if the stocks you are purchasing pay dividends as well then you can reinvest those using a Dividend Reinvestment Plan strategy.