Dollar cost averaging refers to an investment strategy in which an investor divides up the total sum to be invested across periodic purchases of the target asset in order to reduce the impact of volatility on the overall purchase.
This is a popular strategy used by many to reduce the impact of unavoidable and unpredictable market volatility on their portfolio. Let us delve into the math to see exactly how it works.
Say for example that the share price of company ABC is $100. From January to February, unfavourable news of ABC is published and the stock price falls from $100 to $50 (a 50% decrease in price). However, the fundamentals remain sound and the stock recovers back to its original price from February to March (a 100% increase in price).
Tom, unaware of what DCA was, decided to use his entire capital of $10,000 to purchase 100 shares of ABC at the start January. By the end of March, he would have just broke even (assuming that he did not panic and sell during the 50% drop, which requires much conviction).
Jerry, on the other hand, read about DCA on a blog post and decided to employ it. Let us see how his investment has done during the same period.
In January, Jerry used $5,000 to purchase 50 shares of ABC (at a cost per share of $100). From January to February, the value of his investments would have fallen by 50% (from $5,000 to $2,500).
At the start of February, Jerry remains convinced that the fundamentals of the stock has remained unchanged, and that ABC is severely undervalued at $50. Thus, he invested the remaining $5,000 into ABC, purchasing an additional 100 shares. He now owns 150 shares for a total cost of $10,000, reducing his cost per share from $100 to $66.67 ($10,000/150). As the price rises back to $100 from February to March, the total value of his investment is now $15,000 ($100 x 150 shares).
His total investment of $10,000 is now worth $15,000, earning a 50% return on his investment thanks to this nifty trick!
You may be wondering, why not wait for stock to crash 50% before entering a position? This way, when the share price doubles (as in the above example), you’ll earn a return of 100%! This is because one can never tell where the price of a share will head in the near term. No one can state with 100% certainty whether the price of a share will rise or fall tomorrow.
Let us now take a look at how DCA can be employed in the real world. The calculations below shows how an investor’s portfolio would have performed if he had invested $5,000 into an ETF tracking the S&P500 index at the start of every year from 2000 till 2021.
As you can see, despite entering the market at the height of the Dotcom bubble and investing through the Global Financial Crisis and Covid-19 pandemic bear market, the investor still made money as long as he stayed the course and invested $5,000 regularly. In fact, he tripled his total contributions!
All too often, investors fall prey to their emotions. They get greedy when they see huge run ups and panic when they see huge declines (as depicted below). This results in them buying at the top and selling at rock bottom. This is how most investors lose money.
Dollar Cost Averaging is thus an excellent strategy to remove emotion from the equation and drown out the noise of the market. As long as we are committed to investing at fixed time intervals, we will not panic sell when crisis strike and instead accumulate more shares at a cheaper prices.
That being said, there are some caveats when implementing DCA:
- higher transaction cost
- you may end up buying more shares of a business that is deteriorating
With respect to the first point, one must strike a balance and not over trade. This is because excessive trading will cause fees to add up and eat into our returns. One method is investing in ETFs/blue-chip stocks regularly every month or quarter (instead of every week). Another method when investing in individual companies is to use DCA when the prices drop substantially (10-20%).
The second point highlights the importance of understanding the fundamentals of a company before investing in it.
Sometimes, unfavourable news such as lawsuits, fines or missed earnings/revenue estimate may cause the stock market to over react, resulting in the share price of the company to fall by 10, 20 or even 30%. Often, investors will panic and sell out of their position, only to see that down the road, the share price hits new highs.
However, there are times when the decline in share price is justified by the deteriorating fundamentals of the business. For instance, with the onset of E-commerce, many retail businesses that are unable to keep up with the trend are seeing their profits being eroded and blindly buying more of these businesses because of DCA is a losing strategy.
Thus, an intelligent investor will first access whether the fundamentals of the company has been affected by asking himself questions such as the following.
- Is the situation is a one-off event or one that has lasting impact on the company?
- Has the ability of the company to earn money has been affected?
If the impact is temporary and the business model remains intact, the investor should have the conviction to hold or even buy more shares to lower his average cost. However, if the fundamentals are indeed deteriorating, the investor should then sell out of his position and take the loss instead.
Thus, understanding a business (or the index) is key to implementing DCA effectively.
To end this post, I would like to emphasize the importance of having a plan when investing. Without a plan, we are vulnerable to our greatest enemy, our emotions.