What is dollar-cost averaging?

Dollar-cost averaging (DCA) is a great investing strategy because, in the long term, it can protect the investor from market volatility and reduce the amount they spend buying shares. So, over time, investors could end up investing in more assets for less. But, as with anything in the world of finance, it isn’t all quite that simple. 

There’s no guarantee that things will go your way. So, while dollar-cost averaging is, in many ways, a relatively savvy approach to investing, you’ll need to balance the benefits and risks before diving in headfirst. 

We’ve rounded up all the most crucial information to answer the question “what is dollar-cost averaging?” once and for all. From frequently asked questions to the pros and cons of different investing strategies, this guide has all you need to know to decide whether it’s the right investment approach for you. 

Let’s get to the following commonly asked questions:

• What is dollar-cost averaging in simple terms?
• How does dollar-cost averaging work?
• What is the difference between dollar-cost averaging and market timing? 
• What are the advantages of dollar-cost averaging?
• What are the disadvantages of dollar-cost averaging? 
• Why is dollar-cost averaging more suited towards retail investors? 
• Should I use dollar-cost averaging? 
• Is DCA a good strategy?

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Q1. What is dollar-cost averaging in simple terms?

With dollar-cost averaging, rather than paying one lump sum of money, you invest in a financial product over a specified period of time. So, it’s a strategy that involves a person investing a fixed sum at regular intervals, whether that be weekly, monthly, or yearly. This means they’ll receive more shares when prices are low or less when they’re high.

Often used in retirement planning, it can also be a great way of getting involved in index funds, mutual funds, or a managed fund. It’s a strategy that helps investors to better manage risk because it increases their chances of paying a lower overall price for the stocks they invest in.

Q2. How does dollar-cost averaging work?

Unlike lump sum investing, when you invest using dollar-cost averaging, you don’t know how many shares you’ll end up with when you decide how much you want to pay. To give you a better idea of how this might work, let’s use an example of dollar-cost averaging. 

Say you want to invest $1,000. With dollar-cost averaging, you can split that set amount up into smaller regular payments over a period that suits you. If you wanted that period to be, for example, 10 months, then you’d invest $100 each month. However, due to the inherent nature of the stock exchange, you wouldn’t receive the same number of shares for each payment. 

At times when share prices are as low as $5 each, you’d add 20 to your portfolio. But, in months when prices rocket up to $10 each, you’d only receive 10. The idea is that you’ll end up paying a lower average share price throughout your investment, with the dips and rises in the market ultimately levelling out by the time you’ve made your last payment. 

In many ways, it’s a great way to invest in stocks and shares because it can shield you from the worst of the market’s volatility. However, you’re also less likely to make your fortune with dollar-cost averaging unless you have a specific strategy in play. For example, DCA’ing into assets in a bear market; with the intention to sell during the peak of a bull market. Timing is also key to this strategy, I.e. if you have a short-term investment thesis vs. you want to accumulate assets over a long-term horizon.

Note: If you’re unsure if it’s right for you, speak to a financial advisor to find out if it suits your short and long-term investing goals. 

Q3. What is the difference between dollar-cost averaging and market timing? 

The investment strategy people tend to be most familiar with is called market timing investing. Also known as value averaging, with this approach investors pay one lump sum for stocks, shares, or other assets in the hope that they do so when prices are low and gains will be high. This involves timing the market just right, which is difficult (if not impossible) to do every time.

For market timing to work, then, investors have to stay abreast of market fluctuations, ideally using approaches such as fundamental analysis and technical analysis. By contrast, dollar-cost averaging is a passive investment strategy. Unlike market timing, it doesn’t offer great short term gains, it’s a good way to cash in on changes in the market with little effort. 

Q4. What are the advantages of dollar-cost averaging? 

The biggest advantage of dollar-cost averaging is the fact that it mitigates some of the risks of the stock market. That’s not to say that it will shield you completely from downswings. Every investment strategy carries risk and this one is no exception. But, when you aren’t making a lump sum investment, you don’t have to worry about every small fluctuation.

By paying a fixed amount at intervals of your choosing, you can enjoy periods where prices are low. You could even buy into a bear market, safe in the knowledge that, once prices start to rise again, you’ll likely already be sitting on a good bank of shares. 

It’s also a great way to better manage the costs of investing. You may, for example, want to make a sizable investment but not have the means to do so all at once. In that case, spreading the cost over a period of time that makes sense for you and it’ll allow you to accumulate more assets vs a lump-sum buy order.

Q5. What are the disadvantages of dollar-cost averaging? 

While a great choice for many investors, dollar-cost averaging isn’t perfect. When you decide to use dollar cost investing, there’s no way of telling whether your regular investments will pay off. Particularly if you find yourself regularly investing in a rising market, the returns you see are likely to be weak compared to those of a lump sum investment. 

You just can’t predict whether price fluctuations will fall in your favour. Add to that the fact that you’ll probably have to pay additional fees to online brokers for each transaction that you make and you’ll see that there are definite downsides to consider. Overall, though, for certain types of investors, dollar-cost averaging is generally the best course of action. 

Q6. Why is dollar-cost averaging more suited towards retail investors? 

DCA’ing is particularly beneficial for investors that don’t have huge sums of money to invest immediately. Rather than dipping too far into their checking accounts and struggling to cover one large payment, they can instead pay in instalments for stocks, shares, and other financial products and reap the rewards further down the line. 

It’s also great for investors who are just starting out and trying to get their heads around the investing basics. With dollar-cost averaging, they don’t have to try to figure out if the price is low enough to maximise gains. Instead, they can witness and learn from the effects the stock market’s fluctuations have on their investments as each new payment is made. 

Q7. Should I use dollar-cost averaging? 

If you want to invest in shares, stocks, or other financial products for the first time, then you should consider dollar-cost averaging. Simply decide on the amount of money you want to invest overall, figure out the best way to split your payments up, and you can start accruing assets with relatively little stress. 

Just bear in mind that, while it is in many ways a lower-risk option, you should only ever use money that you will not need in the near future and that you have immediate access to. 

Important: Investing money you got from a loan or savings account is not advised when you’re investing in the stock market, regardless of the approach. 

Q8. Is DCA a good strategy?

Once you start making your payments, there’s minimal strategising involved in dollar-cost averaging, but that doesn’t mean to say there’s no need for financial planning. You still need to weigh up your overall goals with your current financial situation and figure out how much you’d like to invest from there. 

You won’t know what average price you’ll eventually get for your shares until your investment has run its course and every price drop has been taken into account. However, dollar-cost averaging strategies still need to be well-considered if you want to make the most of them. 

A solid dollar-cost averaging strategy should revolve around assets that you are comfortable holding for a long duration. This means you believe in the financials behind the company and you expect that these fundamentals will continue to grow over time.

Plus, you’ll need to decide much you want to spend on each regular automatic investment and via which platform (for example a robo advisor or a self-managed investment account). To do so, think about how much you have to invest and the gains you’re likely to make based on how your asset of choice is currently performing. 

With the rise of crypto assets and meme stocks, a variety of relatively new terminologies have recently surfaced, such as:

• HODL: This stands for ‘hold on for dear life.’
• YOLO: ‘You only live once.’ A term that implies to go ‘all in’ on a specific asset.
• Degen: This stands for ‘degenerate,’ and is often associated with Robinhood traders and meme stocks.
• FOMO: ‘Fear of missing out.’
• FUD: ‘Fear, uncertainty, doubt.’
• BTD: ‘Buy the dip,’ a term that is directly correlated with the DCA-mindset that implies to buy when an asset has a pullback in price.

Summing up

With the right DCA strategy, you can accrue valuable stocks, shares, crypto and other assets over time that could eventually lead to big gains. Just be mindful that there are risks involved and ensure that you invest cautiously and be willing to change your strategy and apply risk strategies such as portfolio diversification, redistribution and rebalancing.

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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs, or financial situation.