A favorite investment strategy among both professional and retail investors is Dollar-Cost Averaging, also called DCA. Even the best traders can find it near impossible to accurately time the market, so this approach breaks up contributions over time to obtain an average price.
It’s a popular investing plan because it works more often than not. It also helps to take the guess work out of investing, which can be ideal for long-term investors that don’t want to spend every day analyzing charts and reading reports. DCA isn’t as straightforward as it may seem though, so I’ve created this guide to help you navigate the pros and cons of this approach.
What is Dollar Cost Averaging?
Before I teach you a bit about DCA, I need to make sure you completely understand this concept. In general, dollar cost averaging involves buying a specific asset or equity over and over again. You have a set investment amount that you want to make on a regular basis, so you continually buy that amount worth of shares regardless of the price.
A variation on DCA removes the regular investments regardless of share price. Instead, you make an initial investment. Whenever the share prices drops below your cost per share, you buy more to reduce how much you’ve paid per share for all shares you own.
Anyone that makes regular contributions to a 401k or IRA may be able to set up automatic share purchases so they don’t even have to think about utilizing the DCA strategy. Your account could be set to automatically buy $200 worth of shares for a specific company on a set date each month. Over time, your investment profits depend less on short-term market fluctuations with this approach.
The biggest benefit to using a true dollar cost averaging plan is that you simply don’t have to worry about price analysis. You figure out how much you want to invest each week or month. That amount is automatically used to buy new shares, no matter the price. Managing an investment portfolio properly can take an absurd amount of time, often on a daily basis. This is the biggest drawback for most investors that can be completely avoided with DCA.
In general, DCA is a strategy that provides the most benefits when used with a long-term holding approach. However, it can also be used by day traders to attempt to reduce losses and/or boost profits.
Let’s say a day trader opens a position for $500 on a stock at $10 per share, so they buy 50 shares. An hour later, the price has dropped to $8. To break even on their trade, the price has to go back up to $10. However, they could buy another 50 shares at $8 each for $400, and then they could break even at a share price of $9. If the price returns to their original purchase price of $10, they’d actually make a profit using DCA.
DCA vs Lump Sum
When you’re only contributing to your investments through your paychecks, you likely have a set limit to invest every month. DCA works best for that scenario. What if you have a large amount of money already in the bank that you want to invest – is it better to use DCA or invest the entire lump sum at once?
In hindsight, a lump sum investment works best when there is a bear market rally, but you can’t always predict rapid price increases. Since you can’t guess what the market will do, DCA usually ends up being the safest bet.
If you have $100,000 to invest, you might be afraid of a large price drop right after you buy if you invest the whole lump sum at once. To protect against this scenario, you can break up your investment into 10-12 parts. Invest 1 part of the lump sum each month until all of it is invested.
When to Use Dollar Cost Averaging
DCA is highly recommended when investing during a bear market trying to time market lows. As an example, Bitcoin and other cryptocurrencies have been dropping in price over the last two months. Instead of attempting to perfectly time a market bottom, you can guess at a market bottom with 10% of your total desired investment. When the price drops 5% – 10% or more below your cost per share, invest another 10%. By continuing to do this during a bear market, you should have a nice cost per share average once the market begins to rise again.
It can also be a great approach to use when you make regular contributions to a retirement fund. This is especially the case when you don’t want to spend much time managing your investments. Just set up your account to buy a set dollar amount of shares in various companies each month to match your contribution amount.
Even more experienced traders to that do a lot of stock and price chart analysis can benefit from using this strategy. Professionals are still ultimately taking educated guesses at future price action. By breaking up a total investment over time, you can help to eliminate the risks of attempting to time the market.
The entire dollar cost average strategy ultimately depends on one key thing: the price of the asset you’re buying must go up over time. DCA can actually be dangerous to uninformed investors that continue to buy more of a stock or other asset as the price continues to plummet until it is essentially worthless.
The LUNA cryptocurrency is an excellent example to use to illustrate the potential dangers of this investment plan. If you invested in Luna anywhere above $40 and didn’t understand what was happening as the price dropped, you may have bought even more coins to lower your average cost per token. This could’ve continued all the way until it was worth less than a penny per coin. An investment worth $2 million just days ago was now worth less than $2.
With LUNA, there’s basically a 0% chance that the price will ever recover. Supply was drastically inflated for a few days, so it went from a reasonable supply of tokens to something more like Shiba Inu’s ridiculous supply counts in the trillions. Using dollar cost averaging to buy during the downfall would’ve been a disaster, so make sure you’re careful about how you use this strategy.