Dollar cost averaging
Encyclopedia
Dollar cost averaging is an investment strategy that may be used with any currency
. It takes the form of investing equal monetary amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
Dollar cost averaging is also called the constant dollar plan (in the US
), pound-cost averaging (in the UK
), and, irrespective of currency, as unit cost averaging or the cost average effect.
investing. One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.
One key component to maximizing profits is to include the strategy of buying during a downtrending market, using a scaled formula to buy more as the price falls. Then, as the trend shifts to a higher priced market, use a scaled plan to sell. Using this strategy, one can profit from the relationship between the value of a currency and a commodity or stock.
where
is the final price of the investment and 
is the harmonic mean
of the purchase prices. If the time between purchases is small compared to the investment period, then
can be estimated by the harmonic mean of all the prices within the purchase period.
claim that DCA reduces exposure to certain forms of financial risk
associated with making a single large purchase, others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.
Middleton claims that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.
and Motley Fool
). The argued weakness of DCA arises in the context of having the option to invest a lump sum, but choosing to use DCA instead. If the market is expected to trend upwards over time, DCA can conversely be expected to face a statistical headwind: the investor is choosing to invest at a future time rather than today, even though future prices are expected to be higher. But most individual investors, especially in the context of retirement investing, never face a choice between lump sum investing and DCA investing with a significant amount of money. The disservice arises when these investors take the criticisms of DCA to mean that timing the market is better than continuously and automatically investing a portion of their income as they earn it. For example, stopping one's retirement investment contributions during a declining market on account of the argued weaknesses of DCA would indicate a misunderstanding of those arguments. The argued weaknesses of DCA do not arise because attempts at timing the market tend to be effective, but because investing in the market today tends to be better than waiting until tomorrow. Applying that knowledge to the average retirement investor's situation would actually support - rather than contest - a policy of continuous, automatic investing without regard to market direction.
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
. It takes the form of investing equal monetary amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
Dollar cost averaging is also called the constant dollar plan (in the US
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
), pound-cost averaging (in the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
), and, irrespective of currency, as unit cost averaging or the cost average effect.
Parameters
In dollar cost averaging, the investor decides on three parameters: the fixed amount of money invested each time, the investment frequency, and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sumLump sum
A lump sum is a single payment of money, as opposed to a series of payments made over time .The United States Department of Housing and Urban Development distinguishes between "price analysis" and "cost analysis" by whether the decision maker compares lump sum amounts, or subjects contract prices...
investing. One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.
One key component to maximizing profits is to include the strategy of buying during a downtrending market, using a scaled formula to buy more as the price falls. Then, as the trend shifts to a higher priced market, use a scaled plan to sell. Using this strategy, one can profit from the relationship between the value of a currency and a commodity or stock.
Return
Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested iswhere
is the final price of the investment and is the harmonic meanHarmonic mean
In mathematics, the harmonic mean is one of several kinds of average. Typically, it is appropriate for situations when the average of rates is desired....
of the purchase prices. If the time between purchases is small compared to the investment period, then
can be estimated by the harmonic mean of all the prices within the purchase period.Criticism
While some financial advisors such as Suze OrmanSuze Orman
Susan "Suze" Lynn Orman is an American financial advisor, author, motivational speaker, and television host.Orman was born in Chicago and received her B.A. in social work. She worked as a waitress in Berkeley, California before becoming a financial advisor for Merrill Lynch...
claim that DCA reduces exposure to certain forms of financial risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
associated with making a single large purchase, others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.
Middleton claims that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.
Confusion
Discussions of the problems with DCA can do a disservice to investors who confuse DCA with continuous, automatic investing. Unfortunately this confusion of terms is perpetuated by many sources discussing automatic investing (such as AARPAARP
AARP, formerly the American Association of Retired Persons, is the United States-based non-governmental organization and interest group, founded in 1958 by Ethel Percy Andrus, PhD, a retired educator from California, and based in Washington, D.C. According to its mission statement, it is "a...
and Motley Fool
Motley Fool
The Motley Fool is a multimedia financial-services company that provides financial solutions for investors through various stock, investing, and personal finance products. The Alexandria, Virginia-based private company was founded in July 1993 by co-chairmen and brothers David and Tom Gardner, and...
). The argued weakness of DCA arises in the context of having the option to invest a lump sum, but choosing to use DCA instead. If the market is expected to trend upwards over time, DCA can conversely be expected to face a statistical headwind: the investor is choosing to invest at a future time rather than today, even though future prices are expected to be higher. But most individual investors, especially in the context of retirement investing, never face a choice between lump sum investing and DCA investing with a significant amount of money. The disservice arises when these investors take the criticisms of DCA to mean that timing the market is better than continuously and automatically investing a portion of their income as they earn it. For example, stopping one's retirement investment contributions during a declining market on account of the argued weaknesses of DCA would indicate a misunderstanding of those arguments. The argued weaknesses of DCA do not arise because attempts at timing the market tend to be effective, but because investing in the market today tends to be better than waiting until tomorrow. Applying that knowledge to the average retirement investor's situation would actually support - rather than contest - a policy of continuous, automatic investing without regard to market direction.