How Dollar Cost Averaging Works

Dollar Cost Averaging (DCA) is a strategy of investing a fixed amount of money at regular intervals. When prices are high you automatically buy fewer units, and when prices are low you buy more units, which has the effect of smoothing out your average purchase price over time.

For more detail, introductory books on regular investing will help you understand the effect of DCA with hard numbers.

The greatest advantage of this approach is that it eliminates the need to time the market. By removing the question of "when should I buy?" and investing mechanically, you achieve disciplined investing free from emotional interference.

Understanding Through Concrete Numbers

Consider purchasing a mutual fund with 30,000 yen each month. When the unit price fluctuates month to month, the number of units purchased and the average cost per unit work out as follows.

  • Month 1: Unit price 10,000 yen → 3 units purchased
  • Month 2: Unit price 8,000 yen → 3.75 units purchased
  • Month 3: Unit price 6,000 yen → 5 units purchased
  • Month 4: Unit price 9,000 yen → 3.33 units purchased
  • Month 5: Unit price 10,000 yen → 3 units purchased

The total investment over 5 months is 150,000 yen, and the total units acquired is 18.08. The average cost per unit is 150,000 yen ÷ 18.08 units ≈ 8,296 yen. Meanwhile, the simple average of the unit prices over the 5 months is 8,600 yen. By investing a fixed amount, you achieved an average cost roughly 3.5% lower than the simple average.

Comparison with Lump-Sum Investing

If you have 1.2 million yen on hand, which is better - investing it all at once, or spreading it over 12 months at 100,000 yen per month? The conclusion is that if the market trends upward over the long term, lump-sum investing tends to produce higher expected returns. This is because the capital is deployed in the market sooner, allowing it to benefit from compounding for a longer period.

However, lump-sum investing carries the risk of a crash immediately after investing. While DCA may underperform lump-sum investing in terms of expected returns, it avoids the risk of committing all your capital at the worst possible moment. For those with limited investment experience or who cannot tolerate large unrealized losses, DCA provides the psychological stability needed to stay the course.

Who DCA Is and Isn't For

Dollar cost averaging is well suited for the following types of investors.

  • Salaried workers who want to invest a fixed amount from their monthly paycheck
  • Beginners who lack confidence in timing the market
  • Those who want to build wealth steadily without reacting emotionally to market swings
  • Those using Tsumitate NISA or iDeCo (Japan's tax-advantaged retirement savings plan) for long-term investing

On the other hand, for experienced investors with substantial capital and the analytical skill to identify market bottoms, lump-sum or tactical investing may be more efficient. Choose the approach that best matches your investment style and risk tolerance.

a practical guide to index investing will convince you of the rationality of riding the market average.