What is Dollar Cost Averaging?
Dollar Cost Averaging (DCA) is an investment strategy where rather than investing all the available capital at once, incremental investments are gradually made over time.
How Does Dollar Cost Averaging Work?
The dollar cost averaging (DCA) strategy is when investors invest their funds in set increments, as opposed to putting all the capital on hand to use immediately.
The rationale behind the dollar cost averaging (DCA) strategy is to be well-positioned for an unexpected downturn in the market without placing too much capital at risk of loss.
If we assume post-purchase, there is short-term market volatility and the price of the purchased asset declines, DCA is designed to provide the investor with the optionality to invest more at the reduced price.
By purchasing more shares at a lower price than the original price, the average price paid per share also declines, which makes it easier to profit since the hurdle (i.e. original share price) has been lowered.
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What is DCA Investing Strategy?
One common mistake made by many investors is attempting to “time the market,” but dollar cost averaging (DCA) can remove the need to time the “top” or “bottom” in the market – which are typically futile attempts, even for investment professionals.
Therefore, DCA saves you the effort of trying to time the market with the optionality to purchase more shares to bring down the average price paid per share – i.e. the “cost basis.”
For investors, especially for value investors and retail investors, the simplicity of DCA can be a useful tool for investing patiently and protects against the impulse to risk the entire amount for higher returns.
The concept of dollar cost averaging (DCA) is to invest your capital in regular portions over time.
- DCA Investing: Since the investment was not made as a single lump-sum payment, DCA can lower the cost basis of the investments. Even if the share price continues to decline, the investor assumes the market will eventually recover.
- Lump Sum Payment: Conversely, if you would have invested the entirety of the amount due in one single payment – i.e. in a poorly timed investment – the only method to bring the cost-basis down is to contribute more capital.
Dollar Cost Averaging Formula (DCA)
The formula for calculating the average share price paid is as follows:
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Suppose an investor in the stock market purchased some shares issued by a publicly-traded company that are currently trading at $10.00 per share.
Rather than spending all of their funds on the purchase, the investor decided to buy only 10 shares to be conservative, with plans to purchase the same number of shares next week.
When next week comes around, the share price has declined to $8.00.
Sticking to the original plan, the investor decides to purchase 10 shares once again.
The total value of the shares is equal to $180.
- Total Value of Shares = ($10 * 10) + ($8 * 10) = $180
Previously, in the first week, the average share price is straightforward at $10.00.
But by the second week, the average share price paid for 20 shares is $9.00.
- Average Price Paid Per Share = $180 / 20 = $9.00
Dollar Cost Averaging (DCA): Rationale and Process
If an investor commits to dollar-cost averaging (DCA), that means the investor will be purchasing more shares when the market price of the asset (e.g. share price) has declined in value.
DCA can signify that there are turbulent times and market selloffs on the horizon, which can cause investors to be hesitant to “double down” on their bet.
However, when viewed from another perspective, purchasing when the broader market is down is better timing – while it is impossible to know the direction the market is headed, if you still regard your initial assessment as true, it is more profitable to buy at lower prices.
On the other hand, if the share price increases, the next action depends on your estimated fair value of the shares.
- If the share price is still lower than its fair value, that means there is remaining upside potential leftover.
- If the share price is higher than the fair value, the risk of overpaying (i.e. no “margin of safety”) could result in negative/low returns.
DCA Strategy: Capital Loss Prevention and Risk Management
The noteworthy drawback to the DCA measure is that an investor can miss out on sizable potential gains by investing in only small increments.
For example, a DCA purchase could have been made on a date representing the bottom, so the pricing of a particular security or index from that point onward only increases (i.e. in this case, a lump-sum investment at the start would have yielded higher gross returns than a DCA strategy).
The point is that while DCA can cause investors to miss out on more attractive purchase prices, it is a risk-averse approach to profiting from large market dips – especially when it comes to riskier securities with substantial volatility like options or cryptocurrencies.
Like with all investing, the dollar-cost averaging (DCA) concept is NOT a guaranteed path to profit or to protect against losses.
Share prices can continue to fall, so it is important to note that DCA is a strategy in anticipation of an eventual rebound – and the catalyst for a potential price recovery should first be confirmed.
If not, there is the risk of digging an even deeper hole that results in more money being lost.
