Trading on the exchange can be a challenging experience. If you buy too soon, you risk being disappointed if the price declines. However, if you postpone and the price rises, you will feel you have lost out on a good offer.
Dollar-cost averaging is a risk-minimization tactic that involves progressively increasing your holding. When you employ a dollar-cost average strategy, you engage in an asset in equal amounts of dollars at regular intervals your purchase is at a range of prices rather than aiming to time the market.
Like most investment techniques, dollar-cost averaging isn’t for all, and there are periods when it makes more sense than others. However, it can be an efficient strategy for overwhelming some mental hurdles to investing.
Let’s understand the nitty-gritty of dollar-cost averaging.
What is Dollar cost averaging?
When buying equities, exchange-traded funds (ETFs), or mutual funds, dollar-cost averaging is a tactic for reducing price risk.
Instead of investing in a single asset at a single purchase price, you divide the investible money to buy tiny amounts over a period at regular intervals with dollar-cost averaging – it reduces the risk of paying a high price before market prices come down.
Of course, prices do not always move in a single direction. However, splitting your purchase into many increases your odds of paying a lower aggregate price over time.
Furthermore, dollar cost averaging allows you to regularly put your capital to work, essential for long-term success.
Let’s understand with an example, using DCA, a $200,000 investment in shares can be undertaken over eight weeks by investing $25,000 each week in the same manner.
The trades for lumpsum investing and the DCA approach are in the table below:
The amount invested is $200,000, with 2,353 shares purchased as a lumpsum transaction. On the other hand, the DCA strategy purchases 2,437 shares, a differential of 84 shares worth $6,888 at the $82 average share price.
As a result, DCA can raise the number of shares purchased when the market is down and decrease the number of shares purchased when the market is up.
| DCA @ $25000 per week | Lumpsum | |||
| Week | Share price | No shares purchased | Share price | No shares purchased |
| 1 | 85 | 294 | 85 | 2353 |
| 2 | 86 | 291 | ||
| 3 | 83 | 301 | ||
| 4 | 81 | 309 | ||
| 5 | 82 | 305 | ||
| 6 | 78 | 321 | ||
| 7 | 80 | 313 | ||
| 8 | 82 | 305 | ||
| Total shares purchased | 2437 | 2353 | ||
| Average share price | 82 | 85 |
What is the best time to employ dollar cost averaging?
When it comes to dollar-cost averaging, it’s crucial. You must, in particular, create and keep to a consistent plan. The strategy’s main advantage is that it allows you to avoid worrying about when to buy in and stop trying to beat the market by splitting the investment into parts.
As a result, you must adhere to it once you’ve set a date, no matter what. The day you select is the perfect day.
Scenarios of the DCA in market phases
When you employ DCA in a falling market, you can own more significant shares as the market prices fall each day, thus helping you get more shares than the lumpsum buy.
In a rising market, Dollar-cost averaging prevents you from maximizing your returns compared to a lump sum buy because the stock rises and then rises again.
However, unless you’re looking to make a quick buck, this circumstance rarely occurs in real life. Stocks are pretty volatile.
In a flattish market, the scenario appears to be the same as the lump sum buy in a flattish market, but it isn’t because you’ve eliminated the danger of market mistiming at a low cost.
For long periods, markets and stocks might move sideways – up and down but ending where they started.
Benefits and disadvantages of the DCA.
Who should use DCA?
You may consider dollar-cost averaging if you are
- When you first start investing, you only have a small quantity of money to invest.
- I’m not interested in the extensive research that goes into market timing.
- Putting money down for retirement every month.
- In a falling market, it’s unlikely to maintain investing.
You may employ another investment approach if
- You have a lot of money to invest.
- You invest in mutual funds through a taxable brokerage account with greater initial investment minimums.
- You love attempting to time the market and are unconcerned about the extra time and research required.
- You’re making a short-term investment
Aside from other aggressive techniques like target asset allocation, diversity, and frequent portfolio rebalancing, an investor should seek to use DCA as an optional strategy.
FAQs
How do you explain dollar cost averaging?
Dollar cost averaging is an investment strategy to mitigate risk while investing. It means that an investor will continue to buy stocks, ETFs and mutual funds by buying smaller units at regularly irrespective of the price point.
What is an example of dollar cost averaging?
Dollar cost averaging allows you to regularly put your capital to work, essential for long-term success.
Let’s understand with an example, using DCA, a $200,000 investment in shares can be undertaken over eight weeks by investing $25,000 each week in the same manner.
The trades for lumpsum investing and the DCA approach are in the table below:
The amount invested is $200,000, with 2,353 shares purchased as a lumpsum transaction. On the other hand, the DCA strategy purchases 2,437 shares, a differential of 84 shares worth $6,888 at the $82 average share price.
As a result, DCA can raise the number of shares purchased when the market is down and decrease the number of shares purchased when the market is up.
Is dollar cost averaging a good idea?
Yes, it is great for investors who do not want to take on a risky venture. It allows you to invest regularly.
