By: Rupesh Oli
Dollar Cost Averaging can be defined as one of the many investment strategies that focus on investing a certain amount of capital you possess on a regular period of intervals rather than the lump sum investments done at once. It tends to reduce the impact of volatility of the stock market upon the investor, when making large purchases of financial assets such as equity, mutual fund, index fund, etc. Regardless of the price currently trading on the stock market, an investor spread out his/her investment at regular intervals.
Dollar Cost Averaging can also be called through its acronym, DCA. In the investment strategy adopted in DCA, the hassle and the mental pressure of an investor trying to better time the market for purchasing the stocks at the best price is completely abolished. The management of risk and reward is a very vital aspect to consider in the stock market. As the ups and downs can be seen in the stock market, it is a very tough task for the investor to better time the market, especially for those who have just started to invest. In such a case, DCA could be the better alternative option for him/her.
Through the division of your capital amount at different time intervals, you are able to buy more stocks when the market is low. On the contrary, you buy fewer stocks when the market is high. This ultimately lowers down your average cost invested in the stocks. Basically, you would not dump all the capital at once you have allocated, when the stock prices were higher. Instead, you minimize your risk through DCA.
Originally, the term dollar cost averaging arrived from the book of Benjamin Graham “The Intelligent Investor”, in which it was defined as “investing a set dollar amount in the same investment at fixed intervals over time”.
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Illustration of Dollar Cost Averaging Strategy
Let’s illustrate the case reflecting DCA in tabular format presented below.
|Stock Price per Share
|Units of Share Purchased
|$40 (Average Price)
Suppose you have saved a total capital of $7000 to invest in the stock market in the hope of gaining good returns over a period of time.
You have two options: either to invest the whole $7000 at once or divide $7000 into equal amounts to invest in regular time intervals. In this case, the regular interval is considered the end of each month.
Let’s say you divided your lump sum of $7000 into 7 months intervals, with the aim of investing $1000 each month.
As you can see in the table above, you were able to buy 190 shares within the time span of 7 months resulting in an average price of $40, as it can be seen that the market has seen both dips and ups.
What if you have invested your whole amount of $7000 at once when the stock price per share was $50?
In such a scenario, you would have bought fewer shares. You would have bought only 140 shares (7000/50) and your average cost would be definitely $50 as you have bought all your shares at this same price point.
Hence, you can easily notice the difference. You have lowered down your average cost and you bought more shares over the period of 7 months. This is the power of dollar cost averaging that the investors can leverage if s/he has the proper tactics to go forward with this investing strategy ultimately lowering down his/her risk to lose more during the bearish trend of the market.
How Dollar Cost Averaging Can Be An Effective Strategy in Stock Investing?
—DCA eradicates the emotion from your decision-making during the investment in the stock market. Investors no longer need to be fearful and freak out to better time the entry in the market.
—As already showcased above, you are able to buy more shares when the stock price is low. On the contrary, the majority of investors who adopt the lump sum investing tactics tend to sell more with a fear that the market would go down even more.
—It is a very effective strategy for those who do not have large chunks of money to invest at once in the stock market. Instead, they could easily allocate a certain portion of their salary to invest at regular time intervals. DCA gives the chance for investors to start out on a small scale, which will definitely build wealth over the years.
—Very helpful for those with low-risk appetite and who tend to become very nervous regarding the market shifts.
—It tends to lower down the impact caused when a certain investor mistimes the market.
—Can be considered as most impactful, when the market is experiencing a bearish trend because you can buy more shares. Eventually, when the market recovers, you see the big amount of profit you have gathered in your portfolio.
Market Timing in Case of Dollar Cost Averaging
In reality, there is no such thing as perfect timing in the market. It is because it is almost impossible. Today’s lower stock price could be the higher price in the market next week. Similarly, today’s higher price could be seen relatively lower in the coming days due to the market volatility. This is why dollar-cost averaging tends to favor the investors more. In the long term, the price will increase for sure if the investor has selected the stocks of the company with strong fundamentals and those showing good consistency on return over the period. The majority of investors have attempted to perfectly time the entry in the market when the price of stocks seems to be lower. However, it is unpredictable how the market will move forward with lows and highs.
It is difficult to predict how higher the stock can go and how lower it can fall. Even the majority of professional stock pickers fail in this aspect. Thus, investors with very little knowledge can go with the DCA, if s/he finds it harder enough to time the market. What you require is the fixed amount to make an investment and the commitment to invest at regular intervals. If you decide to go with the market timing, you may wait very long in order to perfectly enter the market causing a delay in investments based on the market performance. If you possess the feeling that you mistimed the market, it may lead to regret, and you, as an investor, have more focus on investing the capital at the right time, which may lead to higher returns or losses.
However, as you remove emotion from your investing in DCA, your focus will be on the consistency in terms of investment of regular time frame and you do not care about the current market performance whether it is going up or down.
Drawbacks of DCA
Despite the benefits that investors tend to enjoy through Dollar Cost Averaging, it possesses some drawbacks as well. You could indeed enjoy a handsome amount of return in the long run because when the market was on a bearish trend, you were able to buy more shares with the fixed amount allocated. What if the market was in a bullish trend instead of bearish? You could only enjoy a certain profit when the market surpasses the previous peak level. Also, you get less bang for your buck when the market price is high, and it is obvious that you would be buying the shares at a premium price at that point in time.
When you are adopting DCA, you are paying brokerage fees on a regular basis along with the buying of shares. When you would have done lump-sum investing, you pay the brokerage fees at one point in time only. Further, you tend to miss out on the benefit you could have gained through a lump-sum purchase. Suppose market dips and ups favored you and you managed to lower down your average cost. But what if you only manage to buy when the stock prices are higher. In this scenario, you could increase your average cost instead of lowering it.
Moreover, if you are focusing on dividend-paying stocks, dollar-cost averaging might not be the perfect alternative for you. Since you will be doing investments in small chunks, you will not enjoy enough dividends. Further, if you could only manage to allocate a few numbers of stocks in your portfolio before the book closure date, you could only enjoy lesser dividends. However, it is completely opposite in lump sum investing. It is because you would have invested a high amount of capital directly at once, the number of shares at that point of time will definitely be higher as well. Hence, the dividends you would be getting would also rise.
Dollar-cost averaging has been in debate for a long period of time whether it really benefits the investors or not when compared to lump-sum investing. Financial advisors like Suze Orman claim that it is a perfect strategy to reduce the financial risk associated with a single large purchase, whereas Timothy Middleton makes a claim that dollar-cost investing is not a sound investment strategy. Recent research conducted showcases the DCA trade-off between two aspects in terms of regret of investors. One through the investment into a bearish trend and the other one, through making the most out of a bullish market.
To conclude, dollar-cost averaging can be one of the many strategies for beginner investors as well as experienced ones. Although, lump-sum investing could favor you if you could correctly time the entry in the market. However, it is considered a very tough decision to adopt by investors as it is almost impossible to perfectly time the market. Hence, it is always advisable to minimize the financial risk, if you are not fully aware of what you are really trying to achieve in the market. In the long run, investors tend to lower down their average cost invested along with the allocation of the high number of stocks in the portfolio as illustrated in the above table, if compared to lump-sum investing. Before adopting DCA as your next strategy, it is advisable to be aware of some drawbacks it possesses as well so you could balance out both the positive and negative aspects of it before making an investment in the market. Nevertheless, dollar-cost averaging is considered as one of the effective strategies during stock investing.
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