The basic principle that stock markets work on is “buy low, sell high”. This works fine if you keep a close eye on the market and time your buying/selling accordingly. but this may not work in all the cases. Some people stop buying when the price starts rising, fearing that they might overpay. Others will start selling when the prices starts coming down, afraid that they might even lose whatever little profit they would be making. When you start timing the market, you might miss its best performing cycles.
A way to stop timing the market and take the guess work out of investing is DCA. It basically involves investing a fixed amount of money at fixed intervals of time, regardless of how the market is doing; Say investing a total of $12,000 over a year, $1000 per month. Since the amount of money being invested is fixed, you’ll be buying more shares when the price is low and less shares when the price is high. So the share prices will average out in the long run and you might end up making a tidy profit.
There are a few things worth noting about DCA. First one is that it does not always guarantee a profit. You make profit in DCA only if the ending price of the stock is higher than the average monthly price. And that cannot always be guaranteed. Studies have shown that DCA under-performed 2/3 of the times when compared to lump-sum investments. Second thing to note about DCA is that you have to have a lump-sum amount to start DCA. If you invest, say $1000 every month, out of your salary, then that is not dollar cost averaging. DCA comes into picture when you consciously decide to invest regulary as opposed to doing a lump-sum investment.
DCA is also known as ‘Contant-dollar Plan’.