Dollar Cost Average – definition and put in practice

Manuel Lalanne

5 Apr, 2024

Manuel Lalanne

5 Apr, 2024

There is a wide variety of strategies, approaches, and manuals that can be applied when it comes to investing. And while each investor has their style, determined by their goals, financial profile, and experience in the field; some strategies prevail and dominate over time due to their high efficiency. Today we will focus on one of the best investment strategies, simple and suitable for anyone, even more important for beginners. It’s called “dollar cost averaging” (DCA).

What is the Dollar Cost Average?
And How does it work?

Dollar Cost Average means investing for the same amount of money each month or each quarter, while the alternative option would be to invest it all in a single point in time. You can already predict what are the main advantages and disadvantages of DCA, and we will explain in this article why we highly recommend DCA.

If applied in common stocks, as the number of shares that can be bought for a fixed amount of money varies inversely with their price (the higher the price per share the lower the amount of shares you can buy with a fix amount), DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.

There are only two parameters that the investor needs to decide when implementing this strategy: the fixed amount of money available to invest each time and how often the funds are invested. This leads to an automatic investment system that doesn’t require much time, expert judgment and knowledge.

To have success with DCA it doesn’t matter the actual price of the stock nor the tendency. Regardless of that, the effectiveness of the method relies on the investor, who should respect the previously determined amounts and periods of investment. There’s no other secret than planification, perseverance, and a little patience.

Benjamin Graham, a man of renown in the field of investments, was the one who first coined the dollar cost average term. He said in his book The Intelligent Investor (Warren Buffet’s favorite book): [DCA] “means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.”

Practical example

 Let’s suppose an investor decides to allocate $100 each month to invest in a fund tracking the S&P 500 index, which trades at different prices each month.

  • In the first month, the fund’s price per share is $50, so with the $100, the investor buys 2 shares of the fund.
  • In the second month, the price per share of the fund decreases to $40. With the other $100, the investor buys 2.5 shares.
  • In the third month, the price per share increases to $60. With the $100, the investor can only buy 1.67 shares.

After three months, the investor has invested a total of $300 and has acquired a total of 6.17 shares of the fund. If we sum the number of shares purchased and calculate the average cost per share, we find that the weighted average cost per share is approximately $48.53.

This example illustrates how dollar cost averaging allows the investor to buy more shares when prices are low and fewer when prices are high, resulting in a lower average cost per share compared to if they had invested a fixed amount at a single point in time.

Advantages and disadvantages of DCA

Let’s start with a disadvantage of DCA regarding transaction costs: the repeated investing called for by dollar cost averaging may result in higher transaction costs compared to investing a lump sum of money once. Additionally, in a rising market, investors may miss out on potential gains by continuously purchasing at higher prices.

Even so, a huge advantage of this strategy is that it can reduce the overall impact of price volatility and lower the average cost per share. It’s definitely a low risk and long term approach, by having this in mind you can reduce anxiety and put a break on impulsive decision making against changing markets.

It’s also convenient in both bull market and bear market contexts. If there is a bull market, previously acquired stocks get revalorized, it’s still the same amount, but now they are worth more. And if there is a bear market, dollar cost averaging allows you to buy more quantity of the active at a lower price.

Lastly, a major advantage for the investor using DCA is not having to make a decision on a day to day basis about the best time to invest the funds. Its simplicity makes DCA a good choice for those beginners looking to develop habitual or automated regular investing.

Investing in the wrong moment has proven to be very expensive for the investor, if there is a crash in the market after the investing moment it could take several years to recover from it. The stock market crashed in 2000, 2008 and 2020, roughly once every seven years. So we certainly know that the market will crash from time to time but the specific moment or year is impossible to predict. This is the main reason why DCA it’s so important. 

Peter Lynch once said “I know we´ve had 96 years of century and the market´s fallen 53 times, we have 53 declines of 10% or more, so 53 declines in 96 years, once every 2 years we have 10% decline. The 53 declines, 15 have been 25% or more, so 15 and 96 years about once every 6 years the market falls 25% or more. That’s what we call a bear market, you know that – and it’s going to happen. I don’t care when it’s going to happen. I would love to know, obviously it would be very useful to know when it’s going to happen. Doesn’t make any difference to me, corporate profits are going to be a lot higher 8 years from now, a lot higher 16 years from now, a lot higher 30 years from now. That’s what I deal with.”

This is what smart and good investors do, they don’t try to predict the unpredictable. Just avoid entering with the whole investment in the wrong moment by doing DCA and that’s it, you will avoid the pains caused by market volatility.

Conclusion

To conclude, we have made clear that the investment strategy of dollar cost averaging can be used by any investor who wants to take advantage of its benefits. You can mitigate the impact of market volatility, reduce the stress caused by trying to predict the unpredictable movements of the market and potentially benefit from lower average costs per share over time. Also, by spreading out investments over regular intervals, you can harness the power of compounding and smooth out the effects of market fluctuations.

While it may not guarantee substantial short term gains, its long term benefits are undeniable, making it a valuable tool for investors looking to build wealth steadily over time. Through consistent and disciplined investing, DCA has shown good long term results in a wide range of investments.   

Dollar cost averaging turns out to be especially useful to beginning investors who don’t want to take the risky decision of picking the most opportune moments to buy (which by the way, we consider no one in the world, not even a sophisticated algorithm, can consistently and accurately predict the best moment to buy or sell). 

It’s a reliable strategy for individuals seeking to navigate the complexities of investing while minimizing risk.

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Manuel Lalanne

Economist | Experienced Financial Risk consultant My Linkedin

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