Dollar-Cost Averaging (DCA) Explained

0. Prerequisites

• None

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1. Preface

You'll learn the following in this article:

• Learning Outcome #1 (Definition) ー Understand what dollar-cost averaging is and is not, and why you should care about it
• Learning Outcome #2 (Characteristics & Examples) ー See examples of how dollar-cost averaging performs in different market conditions and its benefits and disbenefits
• Learning Outcome #3 (Comparisons) ー Briefly compare dollar-cost averaging against other investment strategies and understand the differences
• Learning Outcome #4 (Reminders) ー Understand some pointers & reminders about dollar-cost averaging

By the end of the article, you will have a deep understanding of what dollar-cost averaging is and how it can be instrumental in your personal finance journey!

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👏    Learning Outcome #1 (Definition)

We will start by understanding what dollar-cost averaging is and is not and why you should care about it.

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2. What Is Dollar-Cost Averaging?

Dollar-cost averaging (DCA) simply denotes to periodically buying a fixed dollar amount of a particular investment.

The keywords here are periodically and fixed.

For example, you will purchase $100 (fixed) worth of Apple stocks every week (periodically), regardless of the stock price and market condition.

This way, the investor will be buying fewer stocks when the price is higher and more stocks when the price is lower. And by doing so, the investor reduces the effects that sporadic changes, related or unrelated to the underlying security or economic conditions, might have on the price.

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3. Why Should I Care About?

The goal of dollar-cost averaging is to reduce the risk associated with investing in particular security by spreading your investment over time.

For example, if you had invested all your money into a single stock at its peak price, you would have risked losing all your money if that stock then fell in value. However, if you had instead spread your investment evenly over time by buying that same stock at different prices, you would have averaged out your purchase price and experienced less risk.

Don't worry. We will go more in detail about this below!

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4. What Dollar-Cost Averaging Is Not

You might be thinking: "I save and invest 10% of every paycheck I receive. Am I already using DCA?"

Technically, you are not. Same idea, but slightly different. But let me explain why.

Typically, recurring investments are made by having a fixed amount deducted from their bank account or paycheck and placed into a retirement account (like an IRA in the U.S.) or taxable account. When this money is automatically invested, it has the same advantages and effects as DCA: buying more shares when prices are low and less when they are high. However, this is not the same as DCA. It's referred to as periodic investing or PI.

The distinction is that PI maximizes projected return because you invest the money as soon as you get it.

DCA is when you already have the cash to invest, but choose to invest across a period.

Although the difference is minute, it's imperative to know the distinction to avoid confusion.

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👏   Learning Outcome #2 (Characteristics & Examples)

Now that we know what DCA is and is not, let's go over some examples of DCA in different market scenarios to understand more of its benefits and disbenefits.

First, we'll look at the benefits of DCA and introduce two examples that demonstrate them. Then, we'll look at the disbenefits of DCA using two other examples.

Alright, let's continue!

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5. Comparing Dollar-Cost Averaging to a Benchmark

Before we look at DCA in different market conditions and understand its characteristics, it's essential to compare it with a benchmark.

That said, DCA is typically compared with its close cousin, lump sum investing (LSI), which is when you invest a one-time sum of money.

Comparing DCA with a benchmark, LSI, will help us analyze and understand when to best deploy DCA in our investments.

5.1.   📊   Lump Sum Investing

The following table shows a simple case of using LSI over a year by investing all $1,200 upfront in a stock in January.

• Share Prices ー Sample prices of a share.
• Total Shares Purchased ー Since the stock price was $10 in January (the first month we start investing), we buy a total of 120 shares.
• 🏃 Running Avg. Price / Share Purchased ー Since we bought all of our stocks at a single price point, our running average price per share is constant at $10 per share.
• 🏃 Running Avg. Price ー The average price of the share across the year is calculated (cumulative price / # of months) and shown for reference.

The key thing to understand here is that since we purchased all our investments in January, our average price per share purchased is constant and unaffected by the fluctuation in the share price.

Now then, let's see examples of DCA and LSI to see how each strategy is effective in certain market conditions.

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6. What Are Some Benefits of Dollar-Cost Averaging?

There are 3 key benefits of using DCA.

• 🕐   Minimizes Bad Timing ー One of the advantages of dollar-cost averaging is that it reduces the risk involved in investing in specific security by spreading your money out over time. If you had put all of your money into a single stock at its peak price, you would have incurred significant losses if the value subsequently dropped. However, if you had spread your investment over time by buying the same stock at different prices, you would have minimized the effects of the volatility and lowered your average purchasing price.
• ❤️   Reduces Emotional Aspect ー By investing automatically, you eliminate the emotional element from your decision-making. Regardless of how dramatically the price fluctuates, you will stick to a set amount of money each time you invest in a certain dollar amount of your preferred investment. You avoid bailing out of your investment when the price falls in a wild swing; instead, it becomes an opportunity to acquire more shares at a lower cost.
• 💸   Potentially Lower Average Price ー When you dollar-cost average, you invest in more shares when the share price is low and fewer shares when the share price is high. This may result in lower average costs per share over time.

Now let's look at some hypothetical market conditions that demonstrate DCA's benefits.

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6.1. What Are Some Examples of Dollar-Cost Working In Our Favor?

DCA works best in two particular scenarios:

• Dipping Market
• Volatile Market

Let's take a look at each scenario.

6.2.   📊   Dipping Market

The following table shows a case of using DCA over a year by investing $100 every month starting from January to December.

• Share Prices ー In a dipping market, you'll see that the price of the share drops to $4 at its lowest point in June.
• Total Shares Purchased ー The key thing to note is that the # of shares purchased in a particular month is inversely correlated to the share price. As in, when the share price drops, you buy more shares! Take a look at the # of shares bought in June!
• 🏃   Running Avg. Price ー The average price of the share across the year is calculated (cumulative price / # of months) and shown for reference.
• 🏃   Running DCA Avg. Price / Share Purchased ー The average price per share purchased up to the month. For example, by March, you would have 35.40 shares purchased with $300. Your average would then be $300 / 35.40 shares, or $8.48.
• 🏃   Running LSI Avg. Price / Share Purchased ー Same idea, except in the context of using LSI.

When we convert the table into a chart, we see more of the relationship between the share price, shares purchased, and the average price per share purchased.

And when we compare the running average price per share purchased for the two strategies, we find that DCA ends up with a much lower average.

DCA Avg. Price / Share Purchased	LSI Avg. Price / Share Purchased	DCA Total Shares Purchased	LSI Total Shares Purchased
$6.44	$10.00	186.35	120.00

The average price per share purchased for DCA is $3.56 cheaper, and consequently, you end up with 66.34 more shares just by spreading our investments across the year!

6.3.   📊   Volatile Market

Similar to the dipping market we just saw, the following table shows a case of using DCA over a year by investing $100 every month starting from January to December. However, the difference is the nature of the share prices ー rather than it dipping and rising, the price fluctuates in this example.

• Share Prices ー In a volatile market, you'll see that the share price fluctuates randomly.
• Total Shares Purchased ー Same as before ー when the share price drops, you buy more shares!
• 🏃   Running Avg. Price ー Same as before.
• 🏃   Running DCA Avg. Price / Share Purchased ー Same as before.
• 🏃   Running LSI Avg. Price / Share Purchased ー Same as before.

The # of shares purchased still goes in the opposite direction as the share price, but the average price per share purchased drops at a slower pace than a dipping market (as we would expect).

The interesting thing to note here is that the average price per share purchased still has a downward trend even though the price fluctuates.

DCA Avg. Price / Share Purchased	LSI Avg. Price / Share Purchased	DCA Total Shares Purchased	LSI Total Shares Purchased
$8.86	$10.00	135.40	120.00

The average price per share purchased is not as low as the one in a dipping market; nonetheless, it is still cheaper than if you had just used LSI.

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7. What Are Some Drawbacks of Dollar-Cost Averaging?

There is one main drawback to using DCA.

• Potentially Lower Returns. Historically, the market rises over the long term. Because of this, LSI will offer a higher return than DCI in the long run.

Let's take a closer look at why that is the case.

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7.1. What Is an Example of Dollar-Cost Working Against Our Favor?

As mentioned previously, DCA works against the investor in a rising market.

7.2.   📊   Rising Market

Here, the condition is the same as before but with rising prices this time.

• Share Prices ー In a rising market, you'll see that the share price gradually increases.
• Total Shares Purchased ー Same as before ー when the share price drops, you buy more shares! However, since the price keeps rising, the amount of share purhcased decreases.
• 🏃   Running Avg. Price ー Same as before.
• 🏃   Running DCA Avg. Price / Share Purchased ー Same as before.
• 🏃   Running LSI Avg. Price / Share Purchased ー Same as before.

After 12 months, it is apparent that the average price per share purchased is much greater with DCI.

DCA Avg. Price / Share Purchased	LSI Avg. Price / Share Purchased	DCA Total Shares Purchased	LSI Total Shares Purchased
$14.05	$10.00	85.41	120.00

The average price per share purchased is much higher, making LSI more suitable than DCA in a rising market.

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7.3. What Are Some Other Examples of Dollar-Cost Averaging?

As we just discussed, DCA can be advantageous (dipping or volatile) or disadvantageous (rising) depending on the market situation, but the outcome of DCI is similar to that of LSI in a stagnant market.

7.4.   📊   Stagnant Market

• Share Prices ー In a stagnant market, you'll see that the share price still fluctuates but only between a very small margin.
• Total Shares Purchased ー Same as before.
• 🏃   Running Avg. Price ー Same as before.
• 🏃   Running DCA Avg. Price / Share Purchased ー Same as before.
• 🏃   Running LSI Avg. Price / Share Purchased ー Same as before.

DCA Avg. Price / Share Purchased	LSI Avg. Price / Share Purchased	DCA Total Shares Purchased	LSI Total Shares Purchased
$9.85	$10.00	121.85	120.00

Due to the minor fluctuation in the share prices, the effects of DCA become negligible.

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👏   Learning Outcome #3 (Comparisons)

So far, we've talked about what DCA is and its characteristics in different market scenarios.

At this point, let's discuss how DCA compares with other investment strategies and understand if DCA is suited for you or not!

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8. Dollar-Cost Averaging vs. Lump Sum Investing

Like I previously alluded to, you're taking on more risk with LSI since you're investing a large sum all at once; however, you also have the potential to see more significant returns if the market consistently rises.

In a study by Vanguard, they concluded that LSI performed roughly 2.3% better than DCA about 66.66% of the time.

They advise doing LSI in general since the market will rise, especially in the long run. However, if you are concerned about short-term risk and the potential for regret, DCA may be a better option.

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9. Dollar-Cost Averaging vs. Buying at Dips

In this insightful post, the writer goes in-depth about how challenging it is to beat the DCA strategy even if you could see the future and buy only at the market dips.

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👏   Learning Outcome #4 (Reminders)

Here are a few more things to keep in mind!

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10. What Should I Be Careful About?

DCA works best if you buy your investments with 0-fee commissions. If you have to pay a fee for every purchase (say weekly), the cost of employing DCA will quickly offset or even outweigh the benefits.

Nowadays, there have been more and more brokerage firms with 0-fee commissions, giving you more opportunities to use DCA.

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11. What Else Should I Consider When Evaluating?

In one of the videos by The Money Guy Show, they talk about how an investor should consider a few other things when deciding to use DCA or LSI.

For example, if you decide to invest $1,000 all upfront instead of DCA-ing $100 across the next 10 months, even if the market drops 20%, you'll only be seeing a $200 drop. However, suppose you are using DCA or LSI for 1 million dollars. In that case, you'll really need to consider how you would feel about seeing a $200,000 drop. Would you be able to stomach that and still keep investing? Or will you bail and sell at that point? The sum of capital you are considering to invest can play a crucial role.

Another thing to consider is your emotional and mental well-being. Did you recently lose a loved one? Did you just leave the workforce? Are you currently in a vulnerable state? You may be surprised by how your vulnerabilities may affect your investment decisions if you are.

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12. In Most Cases, You Invest as You Earn

You will be making a regular paycheck through your job or earning dividends from your investments.

That means, in most cases, you will be periodically investing as the money comes in.

And you will only have to worry about deploying DCA or LSI if you suddenly get a large sum through inheritance, a big bonus, selling an asset, or some other events.

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13. What Matters Most Is That You Invest

When you have a sum of cash, it might be hard to invest them all at once. We've all been there, especially if it's your first time investing.

As we discussed above, even if investing a lump sum historically and statistically will give you a better return, if DCA is what will provide you with a bit more peace of mind, then, by all means, it can be an effective strategy.

The most important thing here is that you start investing in a matter that is most suited to you.

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🥳   Final Thoughts

To recap, the goal of dollar-cost averaging is to reduce the risk of investing in a particular security by spreading your investment over time.

However, some studies support that lump-sum investing has historically given a higher return than dollar-cost averaging.

With that said...

If you forecast a bull market and have a high-risk tolerance, then lump-sum investing may be better for you.

If you forecast volatility in the market, are more risk-averse, and prioritize your peace of mind, then dollar-cost averaging may be better for you.