Dollar cost averaging (DCA) is an investment strategy with the goal of reducing the impact of volatility on large purchases of financial assets such as equities.
Dollar cost averaging is also called unit cost averaging or the cost average effect.
By dividing the total sum to be invested in the market (e.g. $100,000) into equal amounts put into the market at regular intervals (e.g. $1000 over 100 weeks), DCA hopes to reduce the risk of incurring a substantial loss resulting from investing the entire “lump sum” just before a fall in the market. Dollar cost averaging is not always the most profitable way to invest a large sum, but it is alleged to minimize downside risk.
The technique is said to work in markets undergoing temporary declines because it exposes only part of the total sum to the decline.
The technique is so-called because of its potential for reducing the average cost of shares bought. As the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA possibly can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
Example
Let’s assume an investor decides to purchase $1,000 worth of XYZ Corp. at the same time every month for four months. In this example, we’ll also assume that the stock first declines in value, but then rallies strongly.
As you can see in the table above, using a dollar cost averaging strategy the investor would have purchased 272.22 shares for a total of $4,000. His/her average price per share for this period would have been just $14.69 (calculated as follows: $4000 / 272.22 = $14.69). With the stock ending at $18 at the end of this period, the investor’s total position would now be worth $4,900 (calculated as follows: 272.22 shares * $18 = $4,900). As a result, the investor would actually show a profit of $900 on his/her overall position despite the fact that the stock declined in value over the full four-month time period (dropping from $20 to $18).
By comparison, if the investor had decided to invest $4,000 in shares of XYZ Corp. all at once at the beginning of this period, then he/she would have purchased 200 shares at a price of $20 per share. With the stock finishing at $18 at the end of the four months, the investor would have shown a net loss of -$400 on the stock.
This example clearly illustrates the benefits of dollar cost averaging, especially during periods of volatile share prices.
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