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Dollar cost averaging

Lesson in Course: Investing basics (advanced, 6min )

I am ready to start investing and understand that I should drop all my money in at once. What is an easy buying strategy to start today?

When we have identified a good investment opportunity, it's often too risky to put all our money in at once. How many times have we heard of a friend or someone we know buying shares, and then the market drops right after? Markets are hard to time, and dollar-cost-averaging reduces the pain when we time it wrong.

Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase.

How does it work?

By breaking up our initial lump sum investment into equal payments, we can spread out our purchases to reduce our risk to market movements. However, like any strategy, there are some disadvantages to dollar-cost averaging.

 

THE Tradeoff

For some downside protection, we are trading our possible upside returns. For example, if we had correctly identified our investment to be a good one, and the asset price keeps going up after the first day we purchase it, then our returns are going to be lower than if we had just made one lump-sum purchase.

Many investors are happy to make this trade-off. In a previous lesson, we covered why downside risk can be such an issue for investors.

 

While not perfect, DCA is a great way to get started because it isn't time-intensive, nor is it very complex. In another lesson, we'll cover value-averaging as an alternative to dollar-cost-averaging.

Here is another video that goes more into more detail about how dollar-cost averaging works over a period of time. It's an 8-minute video but the video explains the emotional advantages of dollar-cost averaging.

Dollar-cost-averaging every month can be an effective strategy for long-term investors, while dollar-cost averaging every week or every 3 days can be an effective strategy for short-term investors.

A quick rule of thumb is no less than 4, and no more than 10 increments. Deploying more than 25% (4 increments) of our investment capital can still expose us to market timing risks. More than 10 increments can mean that we have stretched out our investment over a period of time that's too long and things may have changed so that the investment is no longer a good one.

Glossary

What is Dollar-cost-averaging (dollar-cost-average)?

Dollar-cost-averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase.

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