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What is DCA: Dollar Cost Average Explained

BitForex Editor
Jan 19, 2021

Introduction

Risk. If you could sum up the investment industry in one word it would be that word, risk. Risk control is the most important skill to acquire if you ever plan to have a profitable investment career.

Few investment tools embody this trait better than DCA(Dollar Cost Average). DCA is an investment strategy that helps you substantially lower the sum you pay for investments and also minimize risk. To learn more about this method of investing, read on as we find out how DCA could potentially be a game-changer for you.

 What is DCA?

Dollar-cost averaging as previously stated is an investment strategy that was designed specifically for risk management. The strategy involves you making investment purchases by dividing your capital and buying the asset you want to acquire in smaller quantities over a period in successive intervals.

This reduces your investment costs and boosts your returns because you buy investments in installments. It also reduces the risk incurred by paying for an asset at a higher price just before the value plummets.

How To Setup A DCA Plan?

Implementing the dollar costing average plan can be as easy as any other strategy you've used, as long as you're willing to do a little pre-investment legwork. Usually, those who make use of the 401k plan are already utilizing this investment tool without knowing it if they pay regularly. The process is fairly simple and straightforward, requiring few steps to get up and running.

First of all, you have to choose what stock or well-diversified exchange trade fund you want to acquire. After you select your preferred purchase, you instruct your brokerage(company acting as your broker) to set up a plan to automatically buy at successive intervals. Sometimes, brokerages don't offer automated plans you can work around that by setting your purchases on a fixed schedule.

Remember, a lot of funds and stocks pay dividends, these can be them be reinvested automatically by your broker according to your instructions. This means you get to continually buy stock and compound your gains in the long run.

When Should You Use It?

A lot of experts make use of Dollar-cost averaging in several of their purchases as a backup plan or as a major tool. But if you are in league with at least one of the groups on the list below you should strongly consider this strategy;

• If you have no interest in becoming a professional investor and unwilling to do the research that goes with it

• Just getting to grips with investing and low on capital

• Uninterested in investing in down markets in the long run

• You're making regular investments in retirement accounts like 401k or IRA

Why You May Prefer A Different Strategy

DCA is an advisable strategy for everyone to use at least sparingly, but there are some situations when you may decide to forgo this tool;

• If you relish the challenge of timing markets and taking the time to do proper market research

• You plan to make a short term investment

• You have considerable capital to invest

Advantages Of DCA

There are several advantages of utilizing the Dollar-cost averaging strategy, a few are;

1. Lower Costs

Purchasing assets at a lower price is a huge possibility using the DCA method because you don't make your purchase on a one-time basis at a point of the value curve. This essentially means that unless your proposed asset is a bad investment, you will more often than not buy at a cheaper rate.

2. Manage Emotional Discipline

Although it may sound too cliché, emotional investments are a real thing. Investors tend to get too attached to the market, this could lead to making poor in the spur of moment choices, like purchasing a stock all because it is hot right now, without doing the required due diligence.

3. Lower Exposure

DCA is a widely used and reliable tool for limiting liability and protecting your investment capital from sudden market fluctuations. Liquidity and flexibility are vital in the market, these are features of what dollar-cost averaging investment strategy provides if utilized properly. It removes the possibility of huge losses from market spikes and protects you from declining markets.

4. Protects Against Bad Timing

The fabled art of market timing is a very tricky skill to learn, even for professionals. It is not an exact science, so although the experience may stand you in good stead, there are no guarantees in the direction of the market. Bad purchases hurt the investment portfolio and affect its value adversely.

Disadvantages Of DCA

Every coin has two sides and although the DCA has earned a good reputation in the market as a reliable tool, there are still quite a few drawbacks;

1. Lower Expected Returns

The theory of high risk-high returns rings true in the investment world, the higher the possibility of failing, the higher the reward, and vice-versa. DCA manages to reduce your overhead cost but at the cost of reducing your percentage returns in comparison with lump-sum purchases.

2. Increased Transaction Costs

Using DCA, you instruct your broker to make purchases at specified intervals rather than a one-time payment, there tend to be higher transaction costs attached. This could negatively affect your total potential profits accrued by the asset.

3. Requires Following Up

This process of an asset purchase is slightly different from other types of payments because it is done in installments. Thus, you will have to be checking up and monitoring each schedule. This sometimes comes across as a hassle, especially if the total profit ends up being similar to that made from a lump sum payment.

The Bottom Line

Just like every other strategy, DCA doesn't always pan out the way you may want it to. Studies have shown that although dollar-cost averaging could prove to be an effective tool for some, there is still a major probability that the lump sum investment strategy(one-time asset purchase) outperforms it.

Despite this proven fact, DCA has time and time again still shown itself to be a reliable and effective strategy to gradually grow your money. Even if you do not plan to make it a major part of your investment plan, it would certainly not hurt to have it in your repertoire with other tools like diversification and target asset allocation.

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