What is Dollar Cost Averaging
Team Lendermarket

What is Dollar Cost Averaging & why do you need to know about it?

When you want to invest, waiting until the markets are at an all-time low is tempting. However, market timing is risky, and you might miss the ideal spot to get in on the investment. ‘Dollar Cost Averaging’ can be used to mitigate that.

In this article, we will talk about what Dollar Cost Averaging is and how you can use this technique to your advantage.

Dollar Cost Averaging Explained

Dollar Cost Averaging, sometimes called Euro Cost Averaging or Pound Cost Averaging (depending on what currency is used), means investing in shares of a stock using the same amount in regular time intervals. For example, it could mean buying Amazon stock on the first day of every month for 100 EUR, regardless of the share price.

This strategy gets its name because the cost for a share is averaged out over a more extended period. Sometimes you buy the shares at a high price, sometimes at a low price, and then there are all the moments in between. A more visual example will follow a bit further into the article.

Dollar Cost Averaging (DCA) is commonly used when investing in stocks because price tends to fluctuate quite a bit.

Why Do Investors Use Dollar Cost Averaging?

The principle of Dollar Cost Averaging is regularity. By investing regularly, no matter the share price, you take the emotions out of the equation – which tend to be detrimental to portfolio composition.

Beginner investors especially run the risk of selling their assets during a down phase, waiting for the perfect entry point, or buying more than they initially wanted because they see the stock price increase.

DCA counters all of those negative aspects because the steady cash flow on a predetermined date, whether that be weekly, monthly or quarterly, ensures you invest how much you want to. This way, you focus on the things you can influence, instead of those beyond your control.

DCA vs Market Timing

Whenever investing money comes up, there will be the arguments of “stock prices are too high right now, I’ll wait until they’re lower” or “prices have been steadily declining, I’ll wait till it reaches the bottom”. Both of these statements make sense, theoretically.

In practice, and when you’re in that market phase, no one knows when the top or bottom is reached. By trying to time the market, you run the risk of standing on the sidelines forever. All the while, your money is sitting in the bank account when it could instead be earning you returns.

Even if share prices are high during the beginning of the investment journey, history shows that they tend to even out over time, with a steady uptrend. So, the sooner you take action, the better it generally is for you.

An Example of Dollar Cost Averaging in Action

In the following example, we will compare a person with a ‘traditional’ investment approach following DCA to a person taking their saved-up money and investing it all at once.

Dollar Cost Averaging with Ronny Regular

Ronny Regular decides that he wants to invest 100 EUR every month into stocks for the next six months. His portfolio would develop like this:

TimeInvested AmountShare price# of Shares purchased
Month 1100 EUR10 EUR 10
Month 2100 EUR8 EUR12
Month 3100 EUR7 EUR14
Month 4100 EUR12 EUR8
Month 5100 EUR10 EUR10
Month 6100 EUR7 EUR14
Total investedAverage Share PriceTotal # of Shares
600 EUR8,80 EUR68

*The numbers used are examples and for illustrative purposes

Lump-Sum Investment with Fiona Flow

Fiona Flow saved 600 EUR that she wanted to invest. Rather than waiting, she decides to make a lump sum investment and buy all the shares in the first month. Let’s see how her portfolio develops.

TimeInvested AmountShare price# of Shares purchased
Month 1600 EUR10 EUR 0
Month 20 EUR8 EUR0
Month 30 EUR7 EUR0
Month 40 EUR12 EUR0
Month 50 EUR10 EUR0
Month 60 EUR7 EUR0
Total investedAverage Share PriceTotal # of Shares
600 EUR10 EUR60

*The numbers used are examples and for illustrative purposes

When comparing Ronny’s and Fiona’s portfolios after the six months, we can see that Ronny ended up with eight more shares than Fiona because he was able to take advantage of the dips that happened in months 2, 3, and 6. Waiting until month 3 to invest would’ve given Fiona 85 shares. However, she couldn’t know that this was the bottom.

Thanks to Ronny’s frequent investment, he did not miss out on this investment opportunity.

Pros and Cons of Dollar Cost Averaging

Pros of Dollar Cost AveragingCons of Dollar Cost Averaging

You invest regularly
Invest a fixed amount
Take emotions out of the equation
Automatically benefit from low share prices
Can sometimes buy shares at a high price point
No option to perfectly time the market
When you have a significant amount available, a large chunk of money might be idle

What Asset Classes Benefit from DCA?

Not all asset classes benefit the same from Dollar Cost Averaging. Generally, it is most helpful when the price of a share can have different values depending on the timeframe. This includes:

  • Stocks
  • Cryptocurrency
  • Mutual funds

DCA and P2P Lending

As there is no volatility when investing in a P2P Loan, DCA is not commonly used with this asset class. Yet, it can still be beneficial to make a regular investment into P2P Loans if it helps you stick to your goal and reduces the likelihood of you spending the money.

Conclusion

Dollar Cost Averaging is a valuable tool if you wish to invest in assets with volatile prices while avoiding falling victim to your emotions. It’s also beneficial if you prefer to start investing, instead of just waiting on the sidelines, and it aids with buying the dips in the market.

If you have a significant amount of money available to invest, then depending on your risk tolerance and other factors, it might be better to put that money to work all at once instead of doing DCA. In general, though, Dollar Cost Averaging is usually an optimal choice for most investors.

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