The Dollar Cost Averaging investment method is often considered the opposite of trying to ‘time the market’, as it is seen as an investment strategy that compliments a long-term, set-and-forget approach. Dollar Cost Averaging (DCA) is used by a growing number of retail investors looking ahead towards their retirement or other longer term objectives.
Let’s take a look at some of the popular reasons why you might consider using the method for your own portfolio, some of the reasons against it, and the most effective way to implement it if you choose to.
What is the Dollar Cost Averaging strategy?
When we’re talking about Dollar Cost Averaging (DCA), we’re referring to the practice of making somewhat frequent, incremental contributions to an investment, such as the stock market, over a consistent period of time. This is in contrast to the single, sometimes large investments made in an attempt to pick the low points of the market.
The general logic behind this method is that you may lessen the market timing risk associated with investing your whole portfolio in a single transaction at what may turn out to be a costly entry point.
In other words, if you make a lump-sum investment on a day when the market is rising, you will buy fewer units than you would on a day when the market is falling. You can spread out your investment entry points and maybe decrease your average cost base by using a DCA approach. This allows you to potentially buy more units for the same dollar amount.
The best time to use DCA is when markets are generally trending downward. The technique is less successful in a rising, or “bull” market scenario. Some investors will continue to implement the strategy regardless of the conditions of the market though, and prefer to be less emotionally and mentally attached to the whole process.
Pros of using the Dollar Cost Averaging strategy
- The potential for trading risk may be lower
- The trading costs is usually lower than with active strategies
- You can start small
- It promotes an easy investment approach
- There is less chance of ‘bad’ timing, as it ignores the entry price
- The DCA approach takes emotion out of the equation
Cons of using the Dollar Cost Averaging strategy
- You might pay more in transaction fees compared to other long term strategies
- It might take a while before you make a profit
- Investors may not respond to clear changes in the environment if their strategy is purely passive
How does the Dollar Cost Averaging strategy work in real life?
Let’s try an example that assumes, to DCA’s benefit, that the market is going down.
A large inheritance has been granted to you on the estate of a relative. You’ve decided to invest the entire $100,000 in the stock market in a lump-sum, picking a share worth $50 per unit at that time. You now have 2,000 shares as a result. This is one possible option for investing your windfall.
Alternatively, using the DCA technique with the same $100,000, you decide to invest the figure over a period of ten weeks by investing $10,000 every week. The market is fluctuating but generally declining, and under the DCA approach, 2,083 shares are purchased at an average over the ten weeks of $48 per share, representing a difference of 83 shares that are worth an extra $3,984 from your investment.
Given the above instance, the DCA approach can increase the number of shares purchased when the market is declining. But on the flipside, it can also lead to fewer shares being purchased if the share price is increasing.
Is the Dollar Cost Averaging Strategy for you?
In an ideal world, we’d all be able to purchase stocks (or other assets) when the market is down and sell when it’s up. Attempts to “time the market” often fail though if you don’t have robust trading experience and a reliable trading plan, leading investors to make poor purchases or sales at the wrong times.
When stock prices drop, investors typically sell out of fear. They risk losing money if they sell before the market recovers. When the market is rising, though, investors may feel compelled to buy on the rise. On the other hand, they can find themselves purchasing just before the market crashes.
By spreading out your investments over time, the DCA method may help you invest without becoming emotionally attached to your money. As a result, you are more likely to resist the temptation to try to time the market by consistently investing the same amount of money each year rather than reacting to it.
New investors who lack the knowledge and experience to determine the best times to purchase may benefit greatly from the DCA technique if their goals are over the long run. Long-term investors who are dedicated to investing frequently but who lack the time or interest to monitor the market can also make use of DCA.
Final thoughts
With all that said, the DCA strategy isn’t the best strategy for everyone. There are definitely times when its use would be inappropriate, such as when prices are clearly going up. Before deciding to adopt DCA, it’s important to think about your investing perspective and the market as a whole.
If an inexperienced investor were to use this strategy to buy a single stock without doing any research on the company it could be detrimental. The problem being that the investor might keep buying more stock when they would normally stop buying, or they would probably get out of the position altogether based on more informed judgment.
Dollar Cost Averaging is a strategy that is best used in combination with some level of active management and research so that you can respond to changes in the market environment.
However you choose to invest, make sure you have a detailed and well-reasoned trading plan that takes into account your individual goals and risk profile, and never risk more of your money than you’re prepared to lose.
If you need more help to implement such a strategy, do not hesitate to contact our customer team. Moreover, ActivTrades offers both a CFD trading account for short-term and active trading, as well as a longer-term investment account without leverage, allowing to invest in around 1,000 of the biggest worldwide companies without any trading fees or custody fees.
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