It’s popular in ETF investing and other spaces that show significant price volatility. In this post, we’ll look at what it is, how it works, and how it stacks up against other investment strategies.
What is Dollar Cost Averaging (DCA)?
Dollar Cost Averaging is an investment strategy designed to reduce the effect of price volatility on an investor’s portfolio.
How does DCA work?
DCA works by systemically investing equal amounts, spaced out over time at regular intervals and regardless of price. It therefore helps to remove various forms of emotional reactions to stock prices from the equation.
Its goal is to reduce the effect of price volatility on portfolio, as well as on investment decisions. Because the purchases are distributed across time, some will involve buying while prices are temporarily high, others while they are temporarily low. The outcome is to create a subjective average price for the investor.
To take a real world example: Suppose I intended to buy $3,000 of BTC in 2019; That would have bought me 0.59BTC at a price of $5,049. However, imagine I instead invest $1,000 once a year, starting in April 2019. I would buy at the following prices:
| Date | BTC price (USD) | Purchase |
|---|---|---|
| April 5 2019 | $5,049 | 0.2BTC |
| April 5 2020 | $6,880 | 0.14BTC |
| April 5 2021 | $58,500 | 0.017BTC |
| April 5, 2022 | $43,400 | 0.02BTC |
I’ve bought BTC at a variety of prices. Over time, I would be paying a subjective price made of the average market price over that period. BTC’s price fluctuates, but my BTC price is $28,457. That’s the price of any given BTC in my portfolio, because I distributed their purchase over time and therefore over price points.
That’s a much higher price than 2019 or 2020; I’d have made a lot more money if I’d just bought $3,000 of BTC in 2019. But if you’re not sure what a stock or asset’s going to do, this is a sound investment strategy; I’m paying, on average, far less for the BTC in my portfolio than others who purchase now or at 2020’s highs. This illustrates the purpose of DCA investing: avoiding making a single lump-sum investment at a point that happens to be a spike in the price of a volatile asset. (Note that nothing else about this example is strictly accurate: the amounts are chosen at random, the time intervals are very far apart, and most investors use it as a strategy for investing in stocks, not assets like BTC.)
What are the advantages of DCA?
Done correctly, DCA can help significantly increase the number of shares an investor can buy, while driving down the average price per share paid. The result is more yield (from more shares), for the same outlay.
Who uses DCA investing?
DCA is used by many institutional investors, because they have to balance the security of their capital against the need to earn yield. So pension and 401(k) funds commonly use some version of DCA. Mutual and index fund accounts often use it too.
Outside of institutions, DCA is a solid option for beginner investors who also wish to ensure the safety of their capital while earning some yield, especially in the ETF (Electronically-Traded Funds) space.
Volatility and long-term trends
It’s important to point out that DCA is designed as a hedge against short-term volatility rather than against long-term trends. If a stock’s price continuously falls for a long period of time, there’s a risk that even scrupulously-applied DCA will merely spread out the loss.
DCA and buying the dip
Is DCA better or worse than buying the dip? The answer to that depends on several factors. Most important are risk tolerance and accuracy. Can you afford to be wrong? And are you sure this is the dip? There are some investors who either make wise or lucky decisions, buy assets during temporary dips and realize major rewards. But when most of the market has the same information, investors tend to move together; dips are rapidly corrected. DCA ‘hedges your bets,’ and if done properly, should allow you to buy at a range of price points including dips. Those dip purchases will pull down the average price you pay, without exposing you to the same level of risk as a lump sum purchase.
An idealized example illustrates this best.
| Month | Sum invested | Share price | Shares purchased |
|---|---|---|---|
| January | $1,000 | $5 | 200 |
| February | $1,000 | $5 | 200 |
| March | $1,000 | $2 | 500 |
| April | $1,000 | $2.5 | 400 |
| May | $1,000 | $4 | 250 |
| June | $1,000 | $5 | 200 |
| Total invested: | Average price per share: | Total shares purchased: | |
| $6,000 | $3.91 | 1,750 |
Here, we can see that using DCA in the first six months of a year let this investor acquire 1,750 shares at an average price of $3.91. They bought the dip, and the $5 highs either side, and still came out ahead. If they’d bought only in the ‘dip,’ they might have gotten 3,000 shares at an average price of $2 — if they’d timed it perfectly. More reward, surely, but much more risk.
If they’d simply bought $6,000 in shares in January, they’d have wound up with 1,200 shares at an average $5 each.
Here’s how the three strategies stack up:
| Lump purchase, market price | Lump purchase, buy the dip | Dollar Cost Averaging |
|---|---|---|
| Risk: Mid | Risk: High | Risk: Mid |
| Reward: Low | Reward: High | Reward: Mid |
DCA isn’t ‘better’ than other strategies in some absolute sense; it’s the most reward for the least risk you can get.
Conclusion
DCA is a risk-reduction strategy for investors that doesn’t simultaneously reduce rewards. It helps reduce the emotional component of investment decisions, making it a good choice for beginner investors who are likely to find the process more stressful and complicated. And it allows investors managing large portfolios to ‘average out’ the market, simplifying prediction and other business decisions, which makes it a popular choice among institutional investors. For highly-experienced investors, active strategizing is likely to yield higher rewards.