Dollar-cost averaging (DCA) is sometimes referred to as the ‘constant dollar plan’. The concept is a risk-management strategy that involves dividing up investment funds, and allocating fixed amounts across a portfolio or managed fund. The price of purchased assets is not taken into account, taking away the element of trying to time the market.
DCA is a long term rather than a short term strategy. It’s a good way to build savings and create wealth over a long period of time. In America, dollar cost averaging is used in 401k plans. An employee can allocate a set percentage of their salary to invest in selected stocks, and the investment is automatically made when their salary is paid. Dollar-cost averaging strategies are also well suited to use in conjunction with mutual funds and ETFs.
How does dollar-cost averaging work?
Because a set amount of your investment fund (or salary) is being used to purchase stocks each time, you’ll purchase fewer stocks when their price is high, and more stocks when their price is low. Herein lies the beauty – the automatic purchase of more stocks when their price is low means that your average cost per share is reduced over time.
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Look at it this way – let’s say you have £10,000 to invest. You could use this entire sum to purchase stocks or shares from one company, in one go. Your profit from doing this depends on how well the stock performs. All the predictive metrics in the world can’t account for unexpected changes in the company or dramatic falls in the share price. Therefore, this is a high-risk strategy.
Under the principle of dollar-cost averaging, you could instead allocate £1,000 per month to your chosen stock over a ten month period. By staggering the purchases, the risk of the share price is spread across ten months of market fluctuation (and, hopefully, growth).
Now apply this to a mutual fund or ETF, where your staggered funds are spread even further across multiple stocks and shares in a carefully curated portfolio. When you break it down like this, it’s a very simple principle, and the benefits are clear. The key word in this term is ‘averaging’. By consistently buying more shares at low costs and fewer shares when they’re at a high cost, you’re creating an average share price that balances your investment over time.
Pros of dollar-cost averaging
The main benefits of dollar cost averaging are threefold. As discussed above, the first is a reduction in the impact of market volatility. It protects you from depositing large amounts into stocks and shares at their highest price point. Budgeting for this consistent, repeated investment means you’ll still be buying in volatile and bear markets, reaping the reward where other investors may be too nervous to buy.
The second benefit of dollar cost averaging is that much of the work, calculation and due diligence required of trying to time the market is removed. Trying to buy only at the bottom and sell only at the top is a time-consuming, nerve-wracking, and often fruitless pursuit that requires knowledge, skill, and a healthy dose of luck. It’s so risky, in fact, that many elite investors and financial advisors will implore you not to try timing the market at all.
Lastly, because the amount leaving your fund or salary never changes, not only is it easy to budget, it’s easy to keep emotions or impulses out of the situation. Day trading, non-strategic stock purchasing, and buying stocks on account of tip-offs or hunches can be driven by unhelpful emotions like fear, FOMO, excitement, and greed. An automated DCA investment puts this out of the picture entirely.
Cons of dollar cost averaging
It’s not a con per se, and if it is, it’s an unavoidable one when it comes to any type of investing – DCA doesn’t provide any guarantees or protections in terms of market fluctuations and declining prices. The concept of dollar cost averaging relies on prices increasing over time.
Another downside which isn’t really a downside is the term. You won’t make a lot of money fast with DCA in the way swing trading or a well-placed lump-sum stock purchase can. You like to see slow and steady returns over a longer period of time.
In short, dollar-cost averaging is an easy to understand, easy to implement strategy. It’s particularly well-suited to beginner investors, the risk averse, and anyone trading in highly volatile markets.
There are a few platforms that have specific features around the dollar-cost averaging strategy. Some of our favourite platforms on here are Trading 212 & M1 Finance these two platforms are great for DCA.
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