Dollar Cost Averaging Definition: Day Trading Terminology
Dollar Cost Averaging or DCA is a technique used in investment that allows traders and investors to purchase fixed dollar amounts of a specific investment vehicle. In this case, it is common for the trader to purchase a large quantity of shares when the prices are low and lesser shares when the price is higher.
According to savvy financial experts, using this method does not guarantee one the absence of losses. This technique has been found to help traders and investors make smaller investments over an extended period of time and not as a large sum. The purchase of stock usually takes place each month regardless of what is happening in the market.
How Dollar Cost Averaging Works
We all know that it’s difficult to predict market direction accurately and that is why investing a large sum of money in a particular security is a risky idea. With the Dollar Cost Averaging technique, traders and investors can protect themselves against risks and fluctuations affecting the market. By using the technique above, investors have a chance of purchasing more shares when the prices are low and fewer shares when the prices are high.
The basic tactic employed by investors when it comes to Dollar Cost Averaging is the commitment to invest a fixed dollar amount every month. It is important to know that investors can diversify their investment depending on their objectives and risk profile. As a result, one has the chance of investing in multiple investment vehicles for example mutual funds, ETFs and stocks.
Dollar Cost Averaging Example
Let’s assume that investor A wants to invest $500 for the first month into a mutual fund. He or she is planning to invest the same amount ($500) for the next 5 months. Assume that the share price for mutual funds at the beginning of every month is as follows:
i. First Month – $15
ii. Second Month – $18
iii. Third Month – $10
iv. Fourth Month – $13
v. Fifth Month – $16
Using our previous scenario where the investor invests $500 every month, we can finally calculate the amount of shares bought every month. Here is how:
i. First Month shares – $500/$15 = 33.3
ii. Second Month shares – $500/$18 = 27.8
iii. Third Month shares – $500/$10 = 50
iv. Fourth Month shares – $500/$13 = 38.5
v. Fifth Month shares – $500/$16 = 31.25
To find out the total number of shares bought during the five month period, we are going to sum the values above
(33.33+27.8+50+38.5+31.25) = 180.88 shares
Average price per share is ($2,500/180.88) = $13.82
This means the total worth of the investor will be
(180.88 * 16) = $2894.08
As a result, the trader will have made a profit of
($2,894.08-$2,500) = $394.08
- By looking at the example above, you can attest to the fact that the strategy allows you to experience good returns
- The technique also allows you to cut down on investment risks
- It eliminates the emotional component brought about by price swings
- Allows you to avoid bad timing
- If you were to invest a large amount when the price is high, you will have better returns when compared to investing small amounts spread over a longer period of time
- Research is required in order to identify good investments
The Dollar Cost Averaging technique is perfect for less experienced investors looking for a preset approach. As a result, one is not exposed to market fluctuations or swings. Over time you are bound to make good returns as you continue to cost average into a position. This is great for retirement accounts where you are looking to hold a position for a long time.