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building financial freedomDollar Cost Averaging (DCA) is an investing technique designed to minimize fluctuation risk and lower the average cost per unit of investment. Many studies have been conducted comparing the DCA approach vs other investing techniques such as Dollar Value Averaging (DVA) and Lump Sum (LS). Generally, these studies have found that the return on investment using the DCA approach is worse than DVA and LS. However, DCA is still popular among investors for the following reasons.
The DCA approach encourages you to invest a fixed amount of money at a regular interval, for example, $200 every month. As a result, when the price of an investment is high you will buy fewer units and when the price of an investment is low you will buy more units.
Example: Dollar Cost Averaging - declining market
John has $6,000 and he would like to invest in Risky Corp. He chooses to invest $1,500 every month for 4 months.
| Month | Market Price | Amount Invested | Units Bought |
| 1 | $24.00 | $1,500 | 62.5 |
| 2 | $20.00 | $1,500 | 75 |
| 3 | $15.00 | $1,500 | 100 |
| 4 | $22.00 | $1,500 | 68.18 |
Total number of units = 305.5
Average price per stock = $6,000 / 305.5 = $19.64
Net worth at 4th month = 305.5 x $22 = $6,721
Harry invested $6,000 over 4 months and his closing position investor’s net worth is $6,721. Even though the stock price has fallen over this period from $24 to $22, John still makes a gain of $721.
If John had invested the whole $6,000 during month 1, he would have bought 250 units and his net worth at month 4 will be 250 x $22 = $5,500.
As you can see, DCA is a strong investing technique when the market is going down.
Example: Dollar Cost Averaging - rising market
Potter has $2,000 and he would like to invest in Volatile Corp. He chooses to invest $500 every month for 4 months.
| Month | Market Price | Amount Invested | Units Bought |
| 1 | $12.50 | $500 | 40 |
| 2 | $11.75 | $500 | 42.5 |
| 3 | $15.00 | $500 | 33.3 |
| 4 | $18.50 | $500 | 27 |
Total number of units = 142.8
Average price per stock = $2,000 / 142.8 = $14.00
Net worth at 4th month = 142.8 x $18.50 = $2,641.80
If Potter had chosen to invest the whole $2,000 during month 1, he would have bought 160 units and his net worth at month 4 will be 160 x $18.50 = $2,960.
This example shows that if you expect the market to rise over the long term, then you should use the lump sum investing and not dollar cost averaging.
In summary, DCA is a strong investing technique especially during times of market volatility.