Dollar-cost averaging

Dollar cost averaging (DCA) is an investment strategy with the goal of reducing the impact of volatility on large purchases of financial assets such as equities. 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.

By dividing the total sum to be invested in the market (e.g. $100,000) into equal amounts put into the market at regular intervals (e.g. $1000 over 100 weeks), DCA hopes to reduce the risk of incurring a substantial loss resulting from investing the entire "lump sum" just before a fall in the market. Dollar cost averaging is not always the most profitable way to invest a large sum, but it is alleged to minimize downside risk. The technique is said to work in markets undergoing temporary declines because it exposes only part of the total sum to the decline. The technique is so-called because of its potential for reducing the average cost of shares bought. As the amount of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA possibly can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.

Finance journalist Dan Kadlec of Time summarized the relevant research in 2012, writing: "The superior long-term returns of lump sum investing [over DCA] have been acknowledged for more than 30 years." Similarly, decades of empirical research on DCA has found that it does not function as promoted, and is a sub-optimal investment strategy.

In dollar cost averaging, the investor decides on two parameters: the fixed amount of money invested each time, and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sum 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.

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Wikipedia