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What is Dollar Cost Averaging (DCA) and should you use DCA?

27 Aug 2022

Afraid of timing the market wrongly? Then dollar cost averaging might be for you.

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What you'll learn

  • What is Dollar Cost Averaging (DCA)?
  • How does Dollar Cost Averaging work?
  • How does Dollar Cost Averaging compare to lump-sum investing?
  • Should you use Dollar Cost Averaging?

TL;DR

  • Dollar cost averaging involves dividing your money into equal monetary amounts to be periodically invested on a regular basis
  • It is an investing method that reduces the risk of poor market timing and protects your capital
  • If you have the discipline to stick to it, dollar cost averaging will help smoothen out market volatility

You might have heard the term “buy the dip” whenever the price of your favourite stock goes down.

If you liked Meta at $300, you’ll love it at $180. Buy the dip!”

That, of course, may or may not be sound advice depending on the stock price’s ability to recover.

But what you should also realise is that buying the dip involves a fair bit of market timing

Why is that so? Simply because it’s not easy to determine when is a good time to buy the dip.

Do you do it when you’re down 20% or 30%? Besides, what do you do if the dip keeps dipping?

Instead of trying to catch a falling knife, perhaps a better approach would be dollar cost averaging.

What is Dollar Cost Averaging?

Dollar cost averaging is when you invest a certain amount of money into a certain security on a regular basis, regardless of its underlying price.

For example, you decide to invest $200 into the S&P 500 every month. You continue to repeat this on a monthly basis even if the price drops or climbs higher.

This is a great way for individual investors to get started with buying a stock or ETF because you don’t have to pay that much every month.

It’s also a great way to reduce your risk if you want to invest a large amount of money into a single security.

Suppose you get $20,000 from the maturity of an endowment plan your dad bought for you many years ago.

In January 2022, you decide that you want to allocate all that money into Microsoft.

Now, you could just go right ahead to spend all that money to buy a bunch of Microsoft shares. That would make the proud owner of approximately 60 Microsoft shares with an average cost of $330 each.

But the problem is that you wouldn’t know if the price will go up or down in the near term period.

If the price of Microsoft stock begins to decline, it means that those shares are going to be worth less with each passing month….

How does Dollar Cost Averaging work?

Dollar cost averaging as an investment strategy works by dividing up the total amount to be invested across periodic purchases.

By taking the average price over a period of 12 months, it allows you to reduce the risk of overpaying or underpaying for the shares

This is unlike the example earlier where you would actually be taking a risk by buying into Microsoft stock all at one go.

Instead, you would have benefitted by dollar cost averaging into the company by spending $1,000 every month buying the same stock at the prevailing market price.

That would’ve allowed you to buy some shares of Microsoft at a lower price of $250 in June 2022.

How does it compare to lump-sum investing?

Generally speaking, there are two ways to invest. You try to time the market or you can just forget about timing the market.

Unlike lump-sum investing, dollar cost averaging does not require you to pay attention to market conditions.

You simply keep doing the same thing consistently and automatically on a regular basis.

A boring strategy to be sure, but one that is risk-adjusted and adopts a fuss-free approach to investing.

However it is also possible to simply invest a lump-sum without concerning yourself with the current market sentiments if you have a long-term outlook.

Of course, it wouldn’t be nice to do that right before a big market correction. But remember that any paper losses in the short-term period are inconsequential.

The most important thing is to play the long game!

What are the benefits of Dollar Cost Averaging?

There are a few benefits of dollar cost averaging which include:

  • Reduces investment risk by preserving capital
  • Eliminates the possibility of bad timing
  • Protects us from emotional investing and FOMO
  • Allows you to allocate your savings/monthly pay to invest in a measured approach
  • Gives you a peace of mind during bear markets

However, there are also certain criticisms levelled at dollar cost averaging as an investment strategy. 

These include incurring higher transaction costs and generally giving lower expected returns than lump-sum investing.

Should you use Dollar Cost Averaging?

The question of whether dollar cost averaging is suitable for you depends on your individual preferences.

There are two questions we'd be asking ourselves:

  • Do you prefer to monitor the market for a good entry or would you rather take the stress out of deciding when to enter the market?
  • Also, are you someone who has the discipline to stick to a dollar cost averaging strategy no matter what the stock price is?

The important thing to note, however, is that one investment strategy is not necessarily superior to the other.

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