Dollar-Cost Averaging (DCA) explained
Dollar-cost averaging (or pound-cost averaging) is an investment strategy that strives to automate much of the day-to-day decisions in the process of investing money.
DCA works by dividing the total fixed amount to be invested into smaller, equal sums of money. These drip feed into your chosen assets at regular intervals for a set period of time.
The aim of dollar-cost averaging is to reduce the overall impact of volatility in the price of the target investment asset, because purchases occur at fixed intervals, regardless of the asset’s price.
Since the amount of money being invested each time is equal, you’ll naturally purchase fewer units when the price of your chosen investment asset is higher. But, when the price is lower, you’ll automatically capitalise by buying more shares for your money 🤑
Potential benefits of dollar-cost averaging
Dollar-cost averaging doesn’t suit everyone because you might need nerves of steel to maintain your strategy during times of extreme market volatility… but the approach can yield benefits*:
• Automate your investments 🤖
Dollar-cost averaging is a passive investing strategy, which means once you’ve picked the right investments for you, with an investment app like Plum you can regularly invest, using the power of automation.
• Reduce the temptation to make knee-jerk responses ️🦵
When you commit to investing a fixed, equal amount at regular intervals, you'll still need to conduct periodic reviews, but there's less reliance on needing to monitor share prices on a daily basis.
• Let timing take care of itself ⏰
By regularly investing smaller amounts (instead of waiting until you have a lump sum to invest), it negates the chance that you commit a significant amount of money at a time which is later proven to be unideal market timing, in terms of the price of your chosen assets.
Disadvantages of dollar-cost averaging
When it comes to personal finance, there’s no such thing as a free lunch. So, for every benefit, there is also a potential drawback.
Dollar-cost averaging can only be successful (i.e. make you money) if the investment assets you selected increase in value over time. The strategy can’t protect your investment if the price drops or wider economic conditions see markets fall.
The strategy is based on the assumption that prices in a given financial market overall will eventually rise. However, blindly using this approach to continually invest in a single stock without understanding the underlying company (and knowing when to exit the position) could prove extremely unwise.
Alternatives to dollar-cost averaging
There are many different investment strategies available.
The alternative to dollar-cost averaging would be attempting to strategically place investment orders to ‘buy the dip’ (when the short-term price of your asset is at its lowest).
However, when evaluating these strategies, it’s not merely a case of which is best, but your likelihood of success with each one.
It’s not whether dollar-cost averaging is better than buying the dip… but whether you have confidence you can identify when that dip hits its trough (before increasing in value).
Often, it is when investors focus too heavily on buying the absolute dip that they become paralysed with indecision. They could risk missing out on some of the best trading days if they end up with a lump sum of money saved, which is then not invested if the value of their asset of choice suddenly shows strong signs of recovery 📈
This is the very essence of the investment adage that ‘time in the market beats timing the market’, though how strict you are in adhering to this principle is for each investor to decide for themselves.
How to dollar-cost average
The best dollar-cost averaging strategy for you will be dependent on your financial situation and will normally be dictated by how frequently your wages are paid and regular bills are taken (even if you get paid weekly, this will normally be a monthly cycle).
If you've decided that now is the right time for you to invest, here’s how you can calculate dollar-cost averaging for yourself:
1. Set the amount to be invested 💰
Before investing any money, you should be clear about how much you can afford to invest in each financial cycle, thinking specifically about the anticipated time horizon for your investments.
The best way to do this is by creating a budget and allocating a realistic target amount for your long-term investments. By not over-committing yourself, it helps ensure that you won’t need to liquidate your investments at an inopportune point in time.
2. Choose your investments 🧐
If you’re new to investing and are considering using dollar-cost averaging to invest your money, it may be safer to stick with investment funds. For example, mutual funds often contain company shares from lots of different types of businesses, which is a way to help diversify your overall investment.
3. Set the frequency of buy orders (and reviews) ⏱
Once you’ve decided how much you’re going to contribute to your investments in a given time period, all you need to do is choose how often you’re going to dollar-cost average by placing trades.
If you’re working with a monthly financial cycle, you might choose to make investments weekly, in which case you’d simply divide the total sum to be invested by the number of weeks in that month.
Once you have the strategy set up, the idea is that you should be less likely to make reactive decisions.
However, it’s also wise to schedule regular reviews to ensure that the investments you’ve chosen are performing as expected.
*Please note that if you choose to invest then your capital is at risk, because the value of your investments can go down or up.
You shouldn’t invest in/use any financial product unless you understand its nature and your exposure to risk. If you choose to invest or automate investments, you should be satisfied your choices are suitable for you and your circumstances.
Check out our website if you’d like to learn more about how Plum can help you automate your investing strategy.
Plum is not permitted to provide financial advice. Visit the Money Helper site for free and impartial help.Download Plum