What is dollar cost averaging? Learn how it works

One of the most well-known investment strategies is Dollar Cost Averaging (DCA). For many investors, it is a “safe” method of obtaining better long-term returns.

Throughout the post, we will analyze its main advantages and disadvantages to determine if it is really a good alternative and what its true benefits are.

What is dollar cost averaging?

For those not familiar with the method, DCA consists of investing in a staggered manner in the markets and not making a “one-time” contribution with all the available patrimony for the investment. Or, it could be termed as the art of making periodic contributions during the investment horizon.

The theory behind this method says that we will buy more shares or stocks over time, since when they go down, we will buy more with the same amount of money, reaching a higher final amount.

Example of dollar cost averaging

Let’s see an example with the application of the DCA method:

As we can see, by implementing the DCA method, we have managed to obtain an average price per share of 8 euros.

Now let’s see what would have happened if we had invested the entire amount directly:

We can see that this way we would have had 12.5 fewer shares than through the Dollar Cost Averaging method.

If we saw the first table in a graph, it could have the following form:

This is because, when the price falls (graph with a decreasing trend), we can buy more shares with our investment amount.

Do you want to learn about index funds? Check out this article.

How it works: Is DCA a good idea?

As we have seen in the previous example, the DCA method has been effective throughout the period, however, it would be ideal if we had invested in month 3, when the stocks were cheaper, thus obtaining even more shares than implementing the Dollar Cost Averaging method. It would also be ideal to have sold in month 5, when the stocks were more expensive. Unfortunately, we cannot predict the movements of the market with certainty, and therefore the probability of hitting the bottom or top of the Market is very low, or as the old adage of this world says, only liars buy at the bottom, and sell at the top.

Another scenario that could have happened is that the market continues to fall and investors sell due to panic, or vice versa, that it continues to rise from the first moment and investors buy due to excessive confidence. Despite not getting the maximum benefit at all times, DCA tries to minimize the decisions made due to our emotions. It makes us invest more rationally and, generally, makes us more stable.

Therefore, it is a good strategy because, although it limits the benefits, it also limits the losses in a certain sense. In addition, it must be taken into account that the benefit is not only monetary but also psychological.

Alongside the DCA, there are other money management strategies that can help us invest with a sense of safety, thereby cutting down our losses.

How long should you do a dollar cost average?

As we know, investment funds (and stocks) are influenced by volatility, which implies that they can have quite high market fluctuations due to many reasons, for example, the launch of a new product, a financial crisis, or an inflationary period. Therefore, it is recommended to apply this method for a period of 6 to 12 months if we are investing a large amount of money. However, it can be extended for longer if our volatility and risk profile are more conservative.

Benefits and drawbacks of dollar cost averaging

Next, we will show you a schematic table where all the characteristics, both positive and negative, are observed:

Conclusions

When investing, DCA can help the investor better withstand the fears of the first contributions and spread the risk when entering the market due to the liquidity management it entails. If an investor is pessimistic about the market, DCA is a better alternative, both in terms of profitability and tranquility.

Clearly, this method has advantages and disadvantages, however, speaking from the point of view of benefit, studies show that the difference between DCA and Lump Sum is really small. Therefore, an investor must weigh whether that differential really compensates for other variables such as risk, volatility, and psychological pain.

It should also be noted that this is one of the many strategies within the field of money and liquidity management, so its application is optional. You could also opt for others, such as Value Averaging, the 3% rule, or some other tactics.

👉 Do you want to know other interesting strategies? Then visit our next article: How do I invest in the stock market?

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