What Is Dollar Cost Averaging (DCA) – And Why It Is So Popular

What is Dollar Cost Averaging (DCA)?

Dollar-cost averaging, also known as the constant dollar plan, is an investment strategy for building savings and wealth over a long period. It achieves this goal through systematic investing, where users allocate equal amounts of money for purchasing an asset over regular intervals, regardless of price.

DCA is an effective tool in minimizing the impact of volatility and emotion when investing or purchasing a large chunk of an asset. This is because users can end up purchasing at high prices when making a one-time lump sum investment in an asset.

Whereas dividing the total investment amount into periodic purchases eliminates the risk of entering the market at peaks. While users might end up buying at highs when using DCA, they will also buy the asset at dips, thus obtaining the average price.

Dollar Cost Averaging (DCA) Example

Suppose a user wants to allocate $100,000 to buying Bitcoin. When BTC is at $50,000, that investment will give the user 2 Bitcoins. On the other hand, if the user manages to catch a dip and purchase BTC at $30,000, they will end up with approximately 3.3 Bitcoins.

However, the problem is that markets are unpredictable. The BTC in the above scenario might never plunge to the $30,000 mark. Instead, it might continue its upward trend and hit $60,000. Therefore, simply waiting and hoping to catch a dip does not always play out well.

An alternative method is assigning $5,000 to purchase Bitcoin on a specific day of each month. This way, the user might sometimes end up buying BTC at above $50,000, but they will also catch Bitcoin dips, thus averaging a cheaper price than $50,000 per coin.

An example of dollar cost averaging in practice can be 401(k) plans, which are retirement plans that allow employees to have a portion of each paycheck directly invested into an asset for the long term.

In a 401(k) plan, an employee selects a specific amount of their salary (like $100) to invest in a set of mutual or index funds. At the end of the month, the selected amount will be deducted from the payment and automatically invested in the predetermined investment choices.

Upsides and Downsides of DCA

Among the more prominent upsides to DCA is that it prevents bad timing. As noted above, markets are largely unpredictable. Therefore, an investor would bear extended losses if they invest all their capital at once in a particular investment just before a big market downturn.

Moreover, DCA considerably reduces the effects of volatility and emotion in investing, cutting down on investment risk. This is especially important as retail constantly struggles with FUD “fear, uncertainty, and doubt” and FOMO “fear of missing out.”

Summarizing the benefits of DCA, it can be concluded that it is almost impossible to determine a market bottom, which is where dollar cost averaging comes into play. By helping traders smooth out market timings, the strategy alleviates some of the possible investment risks.

On the other hand, there are also certain downsides to DCA. For one, a DCA investor is more likely to have negative returns if the bull run, where prices continue to rise, overextends the bear run.

Moreover, the theory of the risk and return dynamics is also applicable to DCA investment. In simple terms, since a DCA strategy is subject to exceptionally low risks, it also offers considerably lower returns.

Leave a Reply

Your email address will not be published.

Related Articles
Total
0
Share
Blockster

FREE
VIEW