What is dollar cost averaging?

Dollar cost averaging (DCA) is a trading strategy that some investors employ in an effort to avoid the price fluctuations experienced in an uncertain market. It involves making regular investments of the same amount of money over a certain period of time — weeks, months, or even years — regardless of how the price of an asset moves up or down.

DCA is popular, particularly among less experienced investors and those who do not have the time to keep an eye on the market continually, but it is also somewhat controversial. In this AAG Academy guide, we’ll look at what dollar cost averaging is in more detail, the pros and cons of using DCA, and whether the strategy really works.

If there’s one thing we can be sure of when it comes to trading of any kind (and there aren’t many guarantees), it is that prices are going to rise and fall on a continual basis. Many traders spend countless hours researching markets in an effort to predict changes and trends so that they can make more sensible decisions with their money.

In an ideal world, we buy an asset when the price is low and then sit back and watch its value rise before selling it for a decent profit a short while later. The problem is that none of us can be sure of how the value of an asset will fluctuate — when it will rise or fall, or by how much. All we can do is carry out as much research as possible and take sensible risks.

For those who simply don’t have the time or experience to research a market in-depth and on a continual basis, there is a trading strategy called dollar cost averaging (DCA). This involves investing the same sum of money into a certain asset or a collection of assets on a regular basis over a period of time, regardless of the market value.

How does dollar cost averaging work?

For instance, you may decide that you can spare $200 every month and you want to invest it into something. Rather than researching the best investments every month, you decide where that money will go in advance, then keep making the same commitment every single month. Most importantly, the amount doesn’t change, and you don’t skip investments, based on prices.

This not only negates the need to spend hours carrying out research, but it also ignores any short-term volatility in the market. It is essentially a “set it and forget it” type of approach in which once your decision is made, you allow regular investments to happen — preferably automatically — without worrying about what’s happening to your money in the short term.

The idea is that, over time, dollar cost averaging helps lower the average cost of the amount you spend on your investments. Although you may have some months when you get less for your money because prices are high, there will be other months when you get more for your money because prices are low. The hope is that, eventually, things work out in your favor.

No matter what happens to the market, your investment is always building, and you never need to worry about when to invest, or what to invest in.

What are the benefits of dollar cost averaging?

In addition to the benefits we’ve already touched upon, such as averaging the cost of your investments so that you hopefully spend less over time, DCA is a trading strategy that can be used by any investor who wants to build wealth. It is not only popular among experienced investors, but also those who do not have the experience to keep track of market trends.

DCA is particularly beneficial to those making long-term investments that give market prices plenty of opportunity to go up and down. Over time, you are likely to have purchased more of an asset while its price is low, and you should end up with a considerable profit. That’s assuming everything goes as planned, of course.

What are the disadvantages of dollar cost averaging?

The downside to DCA is that sometimes, things do not go as planned when it comes to investing. Like other strategies, there is always a risk that you will not get back the money you put in — or at least not as much as you put in — should prices fall steadily over time. In this scenario, your investment is continually losing value.

A steady increase in prices isn’t good, either, since the DCA approach means that you will end up buying less over time and you won’t really see any major benefits at the end of it. So, although DCA negates the need for continual research, it still requires investors to make researched and sensible decisions about where to put their money initially.

Examples of dollar cost averaging

One of the most common examples of DCA investing is pension plans, like the 401(k) in the U.S. Employees commit a certain amount of their salary every single month, and that money is automatically invested into the same security, regardless of its price. Depending on the markets, they may see a smaller or larger number of securities added to their accounts in return.

Outside of pension plans, dollar cost average is also used by investors to make regular purchases of index or mutual funds. These work in much the same way, with investors committing the same sum of money every month into the same securities.

References

• Dollar Cost Averaging (DCA) Explained With Examples and Considerations
• What is dollar cost averaging
• Dollar cost averaging