Dollar Cost Averaging (DCA) is an investment strategy designed to reduce investment risk due to price volatility by putting money into an investment on a predetermined schedule, rather than all at once in a lump sum. Dollar Cost Averaging helps smooth out the cost of an investment position by taking advantage of the periodic highs and lows of price movements in particular investments and reducing the risk that an investor overpays for his investment by entering the marketing at the wrong time.
If a stock investor happens to buy a fixed dollar amount of a stock when prices were at a record high, and acquires some more shares with the same dollar amount in another period when prices are lower, then on average, he is able to reduce the overall cost of his position when compared to putting all his money in the stock when prices were high. Dollar cost averaging is suitable for novice investors who are more risk averse and require sticking to a periodic deployment schedule that is followed independently of actual price movements in the market.
For example, Greg is a new investor with $1000 to invest, and wants to put all his money into shares of company X but is concerned about the risk he is exposed to by investing his hard earned money all at once. He heard about the Dollar Cost Averaging strategy and its applicability towards new investors which prompts him to make a schedule of buying shares of company X over a set period of time rather than all at once. He decides to set a fixed schedule buying $250 worth of shares at the beginning of every month for four months. An example scenario is outlined below to compare the outcomes of the dollar cost averaging strategy versus a lump sum investment into shares of company X based on possible price movements and disregarding transaction costs:
…….Average Cost/Share $21.80 Average Cost/Share $25
Current Stock Price $23/share
Current Position Value $1055 Current Position Value $920
Note: The changes in stock price used above are for illustrative purposes only. In reality, such large price fluctuations in a stock price are quite rare and unlikely to happen over a short period of time absent any fundamental changes to the company’s financial health and strategy.
In the above example, we can clearly see that Greg was able to acquire more shares of company X stock with the Dollar Cost Average strategy compared to putting the entire $1000 into shares all at once at the beginning of the first month. After purchasing stocks at the beginning of Month 4, the value of his position in company X stock will be $1055 under the Dollar Cost Average strategy compared to $920 if he had put all his money into shares of the stock in the first month. Overall, this type of investment strategy is more conservative when prices are volatile, and it allows investors to ease into the market over a period of time at a pace they are comfortable with. With less exposure to risk, Dollar Cost Averaging is a more disciplined approach for novice investors. See more in details of this example here.
DCA makes emotionless investing easier –and a reason why it’s a good start for beginner investors. There is a fixed schedule to follow, and emotions don’t play a part in the process. Investors must commit to a fixed dollar amount that they put in and is a lot less scary than investing all in at one time. It’s always a risky choice to try to time the market, and so with this strategy, the cautious investor doesn’t need to time the market for the best entry point –rather just goes and sticks to their DCA schedule.
Now, this isn’t to say DCA is a perfect strategy. DCA has been examined in many studies using real market data, and it shows that the strategy generally does not offer a better outcome compared to investing your money all at once. This is due to the markets commonly being on an upward trend, and you could end up with fewer stocks than if you did the all in strategy. You’re also letting your money sit while waiting to invest that money over time, and that remaining does not generate any returns. Studies show that DCA usually results in a lower long-term return.
However, if you’re a risk-averse investor who is afraid of putting it all on black, and are willing to accept the likelihood of lower returns, then it is a reasonable strategy to execute. Just remember to stick to a strict timetable, invest equally, and don’t spread out this strategy for longer than a year.