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Dollar Cost Averaging

Definition

Dollar cost averaging is an investment strategy with the goal of reducing the impact of volatility on large purchases of financial assets such as equities. Dollar cost averaging is also called the constant dollar plan, pound-cost averaging, and, irrespective of currency, as unit cost averaging or the cost average effect.

Dollar cost averaging is a low-risk strategy often used by people who are new to stock investment and trading. Learn more about the strategy and how it can minimize the risk.

What Is Dollar Cost Average?

Dollar Cost Average, also known as the 'constant dollar plan', is a low-risk investment technique that involves purchasing a particular financial asset on a regular basis for a certain time period at fixed average amount of dollar. This means the number of shares will increase when the share prices decline and decrease when the prices rise for that particular investment.

It is a safer alternative for new traders who may not want to take the risk of investing a large amount all at once. This strategy saves them from placing a large sum of money at the wrong time, and rather allows traders to benefit from the fluctuations over a long period of time.

Different terms are used in different parts of the world depending on the currency of the region. For instance, it is called 'pound cost average' in the UK.

How Does DCA Work?

Let's take an example of an investor who decides to buy $100 worth of particular shares for three months. If the price of stock for each month was 30, 25, and 20 respectively, you will have 12 shares at the average price of $25 each.

A Few Key Considerations

The key to a successful implementation of DCA is to remain consistent and unmoved by the sudden changes in the market. Ideally, the strategy works best for stocks that may be underperforming at the time of first investment but are expected to perform well over a certain period of time.

Investors should pick an investment sum and interval they can stay consistent with for a longer period of time. In case of a positive price increase, the strategy will yield bigger profits over a longer period. Longer periods will also decrease additional expenses such as management or transaction fee in case of index fund.

Moreover, there should be a cutoff point where the investor should opt out of the strategy in order to prevent excessive purchase of a constantly declining stock. While the risk is lower, traders must take the decision to initiate a DCA investment after extensive market research in order to avoid investing in such stocks in the first place.


Further Reading


An empirical examination of the effectiveness of dollar-cost averaging using downside risk performance measures
link.springer.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

Dollar-cost averaging and prospect theory investors: An explanation for a popular investment strategyDollar-cost averaging and prospect theory investors: An explanation for a popular investment strategy
www.tandfonline.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

Dollar cost averagingDollar cost averaging
academic.oup.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

Do lump-sum investing strategies really outperform dollar-cost averaging strategies?Do lump-sum investing strategies really outperform dollar-cost averaging strategies?
www.emerald.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

A simulation model for deciding between lump-sum and dollar-cost averagingA simulation model for deciding between lump-sum and dollar-cost averaging
search.proquest.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

An explicit option-based strategy that outperforms dollar cost averagingAn explicit option-based strategy that outperforms dollar cost averaging
www.worldscientific.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

Mathematical illusion: why dollar-cost averaging does not workMathematical illusion: why dollar-cost averaging does not work
search.proquest.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …

Another Look at Lump-Sum versus Dollar-Cost Averaging.Another Look at Lump-Sum versus Dollar-Cost Averaging.
search.ebscohost.com [PDF]
… is inconsistent with the existence of a mutual fund industry where, on average, money managers … Constantinides, GM “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”Journal of … “The Equity Premium Puzzle.”Journal ofMonetory Economics, 40, 2 …



Q&A About Dollar Cost Averaging


Why should investors use this technique?

The key to a successful implementation of DCA is to remain consistent and unmoved by sudden changes in market prices. Ideally, the strategy works best for stocks that may be underperforming at first but are expected to perform well over a certain period of time. Investors should pick an investment sum they can stay consistent with for a longer period of time in case there is a positive price increase.

What is dollar cost averaging?

Dollar cost averaging is a technique that helps investors to buy more shares when prices are low and fewer shares when prices are high.

Is there any persuasive evidence either way provided about whether or not DCA is a good idea or bad idea?

There is no persuasive evidence either way provided about whether or not DCA is a good idea or bad idea.

What are some considerations when using this technique?

In case there is no positive price increase, or if you decide not to stick with your original plan due to unforeseen circumstances such as job loss or other financial hardships, then you will end up losing money on your initial investment amount because you would have purchased more shares than originally planned on purchasing had you not changed your mind mid-way through investing.

How does dollar cost averaging work?

Let's take an example of an investor who decides to buy $1 worth of particular shares for three months. If the price of stock for each month was $3, $25, and $2 respectively, you will have 12 shares at the average price of $25 each.

Should this article be edited to describe the practice of DCA without providing an opinion pro and con until there's credible evidence one way or another on its effectiveness as an investment strategy?

This article should be edited to describe the practice of DCA without providing an opinion pro and con until there's credible evidence one way or another on its effectiveness as an investment strategy.

Are the benefits of regular investment of relatively small amounts in vehicles that are less accessible than a savings account discussed at all?

No, they are not discussed at all.

Is dollar cost averaging generally considered safe?

Yes, it is generally considered safe.

What does dollar cost averaging help investors do?

It helps investors to buy more shares when prices are low and fewer shares when prices are high.

Should this article include information about how much money you can expect to make with different levels of risk over different time periods for each type of investment vehicle (i.e., stocks vs bonds)?

This article should include information about how much money you can expect to make with different levels of risk over different time periods for each type of investment vehicle (i.e., stocks vs bonds).

Does dollar cost averaging incur transaction costs?

No, it does not usually incur transaction costs.