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Dollar Cost Averaging: The Indispensable Tool For Investment Success
By Simon Quayson
What is Dollar Cost Averaging?
Dollar Cost Averaging (DCA) is an investment strategy outlined by Benjamin Graham in his book, The Intelligent Investor. It’s the practice of investing a fixed amount on a regular basis, into financial assets such as stocks regardless of the current share price.
The objective is to get an average pricing over a period of time. This method of adding investments to your portfolio ensures that you buy more when prices are lower and less when prices are higher.
Emotions associated with timing the markets are curtailed – such as fear of missing out on a price move.
How Dollar Cost Average Works (for the past 80 years)
Now that the basics are out of the way, let’s look at a step by step example. Let’s take an imaginary character named Jason for example, who wants to invest a portion of his income in an equity investment.
He’s allocated a monthly payment of $100 towards equity investments. Using dollar cost averaging, he places an order of $100 each month into his favorite stock “XYZ”:
He purchases the same example sum of $100 each month until the 6th month. Notice that during a temporal market slump in month #4 he is able to buy more stock with the same cash. In the following month the stock jumps to $5 and buys less. He finishes with an average dollar cost of $3.33 and bags 245 shares.
Now let’s compare this to the lump sum approach, he places an order with all of his $600 into his favorite stock “XYZ”:
Jason deposits all his $600 into the investment at once. He sits tight and sees a lot of volatility in months #4 and #5 and ends month #6 with the same stock price he started with.
If Jason sold in month #6 using DCA, his money would be $3.33 X 245 Shares = $815.85.
On the contrary, with the lump sum investment, he would have $4 X 150 Shares = $600.
Jason stands to enrich himself over time if he keeps on using the Dollar Cost Averaging approach. He would automatically have additional investing dollars if he gets a raise, bonus, gift, etc.
However, it’s important to note that DCA is best suited for flat markets and bear markets. The system loses most of its benefits when used in a bull market where the investor would consistently be buying into investments at higher prices.
Essential Safety Measures
The above illustration shows a simplistic cycle of the process and the rewards when using the DCA method over time. But in order to seal the deal, some things must be put in place.
1. Build an Emergency Fund
This fund will take care of immediate financial needs in the event of a temporary loss of income. The rainy day savings must be put in a safe low risk but high-interest savings account.
An economic downturn could do two things: Cause a job or income loss, and secondly, force you to pull money out of equity investments at the wrong price and at the wrong time.
2. Diversify Your Investments
Right off the bat, we're not assuming you’re buying a single stock with DCA. But we hope there is adequate diversification into multiple stocks (or various asset classes) that each receive a reasonably diversified allocation threshold. ETFs or Index Funds are perfect alternatives to stock trading if you’re a beginner.
3. Earn Multiple Streams of Income
You can complete the trilogy by adding additional streams of income. While many may depend on a steady paycheck with hopes of getting more from the employer, a side hustle can be invaluable. A lot of side hustles could be started nowadays with little to no initial investment. By having a side-hustle, you have a fast track to adding more to your portfolio.
Who Should Use DCA?
Dollar Cost Averaging can be used by all who want a fair price for an investment they’re looking to purchase and hold over the long-term. Both individuals and fund managers can profit from this strategy. Warren Buffett was noted for buying Coca Cola stock over a period of months when he was building the initial position decades ago.
According to Charlie Munger his right hand man, they bought almost a third of the volume trading each month until they hit the ownership threshold that they have today.
What Are The Cons?
DCA can be great if you can only invest a bit each month. However, if you have a lump sum to invest all at once, it’s widely acknowledged that this will in fact beat another investor following a DCA strategy.
Unfortunately, most of us don’t have a lot to invest at once, we’ve got to invest X% of our salary each month, and if this is all you can do, using a DCA strategy is a way to ensure you invest consistently.
Nor is DCA a substitute for finding good investments. If you begin investing in a company at $50, then at $40, $30, all the way down to $0, you’ll lose a lot. If you want to use DCA without doing a lot of research, investing a bit into index tracker ETFs each month might be a better option.
The Bottom Line
Dollar Cost Averaging is a great method for buying stocks, indices, ETFs, and other equities. It gives you a great opportunity to lower your buying costs – especially in flat or bear markets. This move will give you value for your investment dollars.
Coupled with an emergency reserve fund, adequate diversification of investments, and new income streams, you’ll surely reap the full benefit of this timeless investment strategy.
Article by Simon Quayson
This investment strategy is for general information purposes only. It does not target any particular person or group of individuals, and therefore does not constitute financial advice or offer or request to begin or complete any financial transaction.
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