Want to lower potential risk, try Dollar Cost Averaging!
by Gregory Schaffer on Dec 6, 2018
Dollar Cost Averaging
What is Dollar-Cost Averaging (DCA)
Dollar-cost averaging (DCA) is an investment technique which involves buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. As a result of the approach, the investor ends up purchasing more shares when prices are low, and fewer shares when prices are high.
BREAKING DOWN Dollar-Cost Averaging (DCA)
The idea behind dollar-cost averaging is to cut down in any investment risks by investing the same dollar amount in the same investment over a period of time. By spacing out an investment over time and dividing the amount of money invested equally, an investor adopting the DCA approach aims to avoid buying shares of a stock or a commodity when the price of that security is high. Over time, some purchases will end up being for a higher per-share cost, and some will end up being lower. The DCA technique does not guarantee that an investor won't lose money on investments. Rather, it is meant to allow investment over time instead of investment as a lump sum. This type of approach is used if you invest in a 401(k) plan, for instance, or if you're concerned about volatility in a particularly turbulent area.
How Dollar-Cost Averaging Works
In many cases, dollar-cost averaging takes place on a month-by-month basis, with the investor buying the same amount of money's worth of a particular security each month. Another method is buying additional shares after pullbacks in the security you are buying. Depending on the investor's investment objectives and risk profile, the monthly contributions can be invested in a mixed portfolio of mutual funds, exchange-traded funds (ETFs) or even individual stocks. Each month, the fixed amount buys shares at the then-current prices. As share prices decline, the fixed amount buys a higher number of shares. Conversely, when prices increase, the fixed amount buys fewer shares. The real value of dollar-cost averaging is that investors don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market. Over time, the investor will end up buying shares at a price closer and closer to average.
Benefits and Disadvantages of DCA
There are a couple of benefits to using a dollar-cost average strategy when investing. First, if you're a newbie to the investment world, this is a good way to start since there's no real emotion tied to it and you're less likely to respond to a swing in price. So long as you maintain a consistent approach and commitment to investing the same amount of money in the same security each month, you don't have to do any more thinking about the investment than that. Investing through DCA becomes a mechanical process. That means you can use the movement as a motivation or opportunity to buy more shares at a lower price.
Secondly, because the market can be so unpredictable, it can give people who may be a little hesitant a good opportunity to start investing. By using the DCA strategy, the cautious investor doesn't have to look for the best entry point in order to invest in a particular security. One simply determines a regular amount of money to invest as well as an investment schedule and then begins the process.
But just like anything else in the investment world, there are some downsides to using the dollar-cost average strategy. Timing is a very key component to investing. While it may help you avoid some bad timing, using a DCA strategy also means you can miss out on some great opportunities. So, you could end up losing on a chance when the market starts to trend upwards. This might be particularly frustrating for investors who watch the price of the security or fund in question. It can be difficult to convince oneself to stay on schedule with a regular investment if the price of the security is rising.
Another potential disadvantage to the DCA approach is that, as the name suggests, it aims for average. In exchange for the ease of the investment opportunity as a result of the mechanical nature of the process, DCA does not intend to provide an investor with above-average performance. Rather, it aims to avoid below-average decisions which were the result of poor timing in a single lump investment. For investors looking to make the most of the changes in the price of a security, DCA is not the best strategy.
Dollar-Cost Averaging Example
As an example, assume an investor invests $1,000 on the first of each month into Mutual Fund XYZ. Assume that over a period of five months, the share price of Mutual Fund XYZ on the beginning of each month was as follows:
• Month 1: $20
• Month 2: $16
• Month 3: $12
• Month 4: $17
• Month 5: $23
On the first of each month, by investing $1,000, the investor can buy a number of shares equal to $1,000 divided by the share price. In this example, the number of shares purchased each month is equal to:
• Month 1 shares = $1,000 / $20 = 50
• Month 2 shares = $1,000 / $16 = 62.5
• Month 3 shares = $1,000 / $12 = 83.33
• Month 4 shares = $1,000 / $17 = 58.82
• Month 5 shares = $1,000 / $23 = 43.48
Regardless of how many shares the $1,000 monthly investment purchased, the total number of shares the investor owns is 298.13, and the average price paid for each of those shares is $16.77. Considering the current price of the shares is $23, this means an original investment of $5,000 has turned into $6,856.99.
If the investor had invested all $5,000 on one of these days instead of spreading the investment across five months, the total profitability of the position would be higher or lower than $6,856.99 depending on the month chosen for the investment. On the other hand, if the investor had saved his $5,000 investment for the third month and bought the shares at their lowest price of $12, the investment would be worth $9,583.41. This represents a significant difference in performance. However, no one can time the market, and the odds that an investor would time his investment to match the lowest point in a share's price trajectory is unlikely, even for experienced investors. DCA is a safe strategy to ensure an overall favorable average price per share.
How to Start Dollar-Cost Averaging
Dollar-cost averaging is a great option for investors without much experience because it is so straightforward. To begin dollar-cost averaging as a basis for your investment practices, follow these steps:
1) Determine a timeframe and regular investment amount
2) Determine a target stock, fund, or other investment area
3) Stick to the schedule
The first two of these steps can be done interchangeably or together. In some cases, an investor may wish to pick a particular ETF or mutual fund, say, or a specific stock. The price of the shares of the fund or the stock may then help to determine the amount to be invested each period. A one-month period for the investment timeframe is standard; for investors looking to build up their investments faster or slower, this can be adjusted. However, in many cases it does not make sense to invest too regularly. Particularly for securities that tend to not change dramatically over a short period of time, this may not result in the most average price. On the other hand, a shorter timeframe does get the investor to his or her total goal investment faster, which may have benefits as well.
The most important thing to do is to stick to the schedule that you've set. For many investors, it's easiest to either automate this or to avoid watching the price of the security aside from the periodic investment events. Monitoring the price of the security may make it tempting to break the schedule and invest early if the price is lower, or to avoid a regular investment if the price is higher. It's crucial also that investors space out their investment over as large a number of individual investment events as possible. This will ensure that the share price is as close to average as possible.
Investing is a process and has certain levels of risk. When something goes beyond your own understanding, seek professional help.
Our advisors at Schaffer & Company Asset Management, Inc. are Certified Financial Planners and have over 34 years of experience. Give us a call anytime to discuss options for investment advisory services.
Gregory L. Schaffer
CEO, President, CFP, CIO, RFC
Article credit: Investopedia