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
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.
- An empirical examination of the effectiveness of dollar-cost averaging using downside risk performance measures – link.springer.com [PDF]
- Dollar-cost averaging and prospect theory investors: An explanation for a popular investment strategy – www.tandfonline.com [PDF]
- Dollar cost averaging – academic.oup.com [PDF]
- Do lump-sum investing strategies really outperform dollar-cost averaging strategies? – www.emerald.com [PDF]
- A simulation model for deciding between lump-sum and dollar-cost averaging – search.proquest.com [PDF]
- An explicit option-based strategy that outperforms dollar cost averaging – www.worldscientific.com [PDF]
- Mathematical illusion: why dollar-cost averaging does not work – search.proquest.com [PDF]
- Another Look at Lump-Sum versus Dollar-Cost Averaging. – search.ebscohost.com [PDF]