What is Dollar Cost Averaging and Should You Use It?
Posted by: Joseph Kuo | August 27, 2021
The most common fear for investors is losing money. This fear can actually inhibit some people from ever investing at all, and it might also lead to selling prematurely or opting for the lower risk investment option time and again. One way to minimize and mitigate the fear of losing money is to go with a risk-reduction strategy such as Dollar Cost Averaging (DCA).
What is DCA?
Dollar Cost Averaging is an investment strategy in which instead of purchasing a security all at once, the amount to be invested is divided into portions to be invested at regular intervals as the price changes. The intended goal of DCA is to provide the investor with a lower average cost of shares over time by taking advantage of price fluctuations. Since the investment amount will be the same at each interval, the idea is that more shares will be purchased when the price is low, while fewer will be purchased when the price is more expensive.
What are the Benefits of DCA?
Those who support the use of DCA claim that it can provide a lower average purchase price for a volatile stock, as purchases of more volatile/high risk stocks with DCA when prices are declining will provide better returns than lump-sum investing.
By only investing a portion of your lump sum, price drops will not impact your portfolio as heavily had you invested a larger portion or your entire sum. Dollar Cost Averaging is meant to mitigate the risks involved in lump-sum investing through which an investor could face major losses if the market crashes or prices fall drastically. Risk-averse individuals may, therefore, prefer to use DCA.
Market fluctuations and losses can greatly affect an individual’s emotional well-being. Further, emotional responses to these ebbs and flows, such as overconfidence or panic, can affect future investment decisions. Since only part of a sum is exposed to the market, losses may not be as drastic. Therefore, many individuals may experience fewer emotional swings than if all of their sums were to be affected, decreasing the likelihood of making emotionally-driven investment decisions in the future.
As such, Dollar Cost Averaging may be good option for those looking to minimize the impact of emotion on their investment choices.
What are the Criticisms of DCA?
Missing Out On Gains
The main argument against DCA is that the portion of your funds that are not initially invested are effectively sidelined and are not given the chance to accumulate any return at all while you wait for the price to vary. Also, if a stock continues to goes up in price, then you definitely lose out on gains.
When to Consider Using DCA
Investors might choose to employ Dollar Cost Averaging for a variety of different reasons, including for investments that are historically more volatile. DCA is also a way to potentially regulate emotional responses. Dollar cost averaging might be used in the following circumstances:
- Volatile investments
- Other long-term investments, such as 401(k)’s or IRA’s
- A time in life where any volatility is not feasible and may cause immediate ramifications (i.e. nearing retirement)
- Individuals who are risk-averse
- Individuals who do not have the funds for a lump-sum investment
The alleged benefit of dollar-cost averaging is that it tries to mitigate the unpredictability of the market and lower the cost of your shares as a result. Ultimately, the decision on whether to use Dollar Cost Average will depend on your unique situation and personal aversion to risk. When choosing how to invest and deciding whether DCA is a worthwhile strategy for you, it is wise to seek the counsel of a financial advisor, who can help you make the best choice for your circumstances and future goals.