What is Dollar Cost Averaging (DCA)?
Dollar-cost averaging (DCA) is an investment strategy. It involves consistently investing small amounts of money over fixed periods of time (weekly, biweekly, monthly, etc.). Some people prefer investing most or all of their funds when a certain good, asset, or share is at its lowest (known as lump-sum purchasing). If they predict the dump correctly this can lead to huge profits. However, it requires a lot of time and technical skills put into analyzing the market and if not predicted correctly can lead to huge losses.
Nowadays even the most skilled traders and analyzers find it hard to predict the markets. Another downside is the emotional pressure that investors have to deal with when they invest bigger amounts of money. This can lead to selling all your assets when prices are falling to avoid further losses. However, if prices increase after that, you will have missed profits and may become dissuaded to trade again. That’s why a lot of people have implemented the strategy of DCA to prevent potential losses and avoid negative emotions.
How Dollar-Cost Averaging Works?
It consists of not investing at once all your money but rather dividing your money and investing equal parts of it consistently over a fixed period of time into chosen assets. These assets can be stocks, goods, cryptocurrencies, etc. The whole idea of this strategy is to limit the effects of market fluctuations by leveling out the average buying expenses for the asset. Also, it doesn’t require to have technical skills, which is perfect for beginners, people who don’t have time to do their own research, and those who want to lower their investment risks. Some companies and apps offer automated DCA which will invest small amounts of money on a regular basis from your bank account or paycheck. This will save you time from doing the same process over and over again if you make every investment by yourself.
Why DCA?
DCA outperforms lump-sum purchasing (buying large amounts of assets at a single price) in almost all market scenarios.
When the markets are falling DCA is second to none. If someone buys 100 units of an asset that is 100$ per unit in a lump purchase, it means that he has invested 10 000$. If the asset’s price falls by 10% every 4 months after one year the losses will be 3000$ and will have 100 units of the asset (33.33 on average for every third of the year).
On the other hand, if DCA is used the losses are smaller. We will assume that an investor will invest 833.3$ once every month for one year (which is equal to 10 000$). For the first 4 months, the number of assets bought compared to those of the lump-sum purchase will be slightly higher (37.03 compared to 33.33). In the second third the difference will become higher (78.696 units of assets compared to 66.666). In the last part, the gap will be the biggest (125.31 units compared to just a hundred). If the prices return back to their levels from the start of the year the first investors won’t have won or lost anything but the second ones will have 2531$ profit.
In flattish markets (when prices move frequently up and down) DCA is also usually the better option unless investors catch the dip which as we previously said can be quite challenging to predict. The dollar-cost averaging doesn’t work that well in rising markets in comparison to lump-sum purchasing. When a stock’s price moves higher and continues doing so, dollar-cost averaging keeps you from maximizing your gains at least in the short term.
Benefits of Dollar-Cost Averaging
The benefits of this trading strategy are a lot and include:
- Universality – it is suitable for everyone. DCA can be beneficial for people who want to lower their investment risk, for those who can’t set aside time to do their own research to make a lump-sum purchase, and especially for beginners who are just entering the market they have chosen;
- Low risk – DCA is significantly less risky than other strategies. Sometimes it may prevent larger sum profits but may also prevent big losses;
- Less stress – unlike the other strategies DCA doesn’t require to constantly watch and analyze the market to buy at the lowest price and sell at the highest price. Missing those moments can lead to high amounts of stress for investors who imply lump-sum purchasing as their strategy;
- Better for long-term investment – in the long term everyone looks for stability which is one of DCA’s key beneficial qualities. If you are planning to do daily trading, DCA may not be the best option for you, and may be better to use other strategies.