What is Dollar-Cost Averaging (DCA)?
Dollar-cost averaging is also at times called “the safest investing strategy. ” Read on to learn how to start dollar-cost averaging and why this strategy is so popular with beginners and experienced investors alike.
What Is Dollar-Cost Averaging?
Dollar-cost averaging (DCA) is an investing strategy that involves investing a fixed amount of money in an asset on a regular basis, regardless of market conditions. Dollar-cost averaging diversifies the price at which investments are purchased and therefore lowers investment risk.
Dollar-cost averaging can help minimize the impact of volatility on a trader’s portfolio and keep emotional trading at bay.
As opposed to market timing, dollar-cost averaging usually offers more predictable returns and is a lot less demanding in terms of market analysis skills.
How Does Dollar-Cost Averaging Work?
Dollar-cost averaging is one of the most straightforward investment techniques in existence. It requires an investor to deposit a fixed amount of money in an asset at regular intervals, regardless of the asset’s market performance. This means that an investor’s money can buy fewer shares/units of an asset when its price is higher and more shares/units when the price is lower. The DCA approach helps average out the overall purchase price and minimize the effect of price volatility on a trader’s portfolio.
When attempting to time the market, traders always run the risk of making wrong predictions, as it is impossible to anticipate how it will fluctuate in the future with absolute accuracy. Dollar-cost averaging eliminates this issue by spreading out the investment entry points and smoothing the fluctuations in price. Statistically speaking, DCA often helps achieve a lower average investment cost compared to market timing strategies.
Dollar-cost averaging is quite popular among beginner investors as it does not require knowledge of technical analysis or deep insight into the workings of financial markets but can produce steady long-term gains with little risk.
Market Timing vs. Dollar Cost Averaging
Market timing is the practice of buying and selling financial instruments based on their anticipated short-term performance. Active investors generally move value in and out of investments to profit from predicted changes in their prices.
The problem with market timing is that it is challenging to implement in practice as financial markets are dynamic and unpredictable in nature. And while if timed correctly, the market timing strategy can bring higher returns compared to dollar-cost averaging, the latter is significantly easier to implement and is safer to use in highly volatile markets.
An Example of Dollar-Cost Averaging
Suppose an investor purchased $10 worth of bitcoin every week from January 2018 through January 2022. Thus, their $2,090 investment would have turned into $11,392.22 of value by the end of that time period. However, if they had made one $2,090 investment in January 2018, by January 2022, the value of their portfolio would only be around $7,782 Here is a detailed view:
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Pros and Cons of Dollar-Cost Averaging:
Pros of DCA:
- Helps avoid the pitfalls of market timing.
- Eases the emotional burden of investing in volatile markets.
- Is less complicated than other forms of investing and requires less time and effort.
Cons of DCA:
- May result in lower returns than a successful market timing strategy
- Requires considerable discipline and patience on the part of an investor
- Only suitable for investors who can afford to make regular investments.
How does dollar-cost averaging work?
Dollar-cost averaging is the practice of investing a fixed amount of value into an asset on a regular basis over a prolonged period. DCA helps reduce investment risk by smoothing out price fluctuations.
Who is dollar-cost averaging suitable for?
DCA is suitable for investors who are not comfortable with the uncertainty of actively timing the markets and prefer steadier returns with minimal risk.
Why do investors use dollar-cost averaging?
Dollar-cost averaging reduces the negative effects of investor psychology and market timing on an investor’s portfolio.
Can you lose money with dollar-cost averaging?
Yes. As with any trading strategy, DCA does not guarantee profits and can not protect investors from steadily declining markets.