Definition: Dollar-cost averaging is that investing strategy where the investor puts in a fixed sum at regular intervals into specific security or combination of different securities irrespective of its price on the due date. Hence, the investor gets more units when the prices are low and vice-versa.
The DCA strategy eliminates the chances of timing the market i.e., making gain from investing in the securities at a most favourable price.
This concept (also known as constant dollar plan) stands over the following four factors:
- Investing a fixed amount;
- in a specific security or combination of stocks;
- at regular intervals;
- irrespective of the stock price on the due date.
It is a suitable way of investing for the people who look forward to wealth creation and progressive future savings.
Dollar-Cost Averaging
How to start dollar-cost averaging?
There are two prominent ways of dollar-cost averaging for an investor:
401(k) Plan
One of the easiest ways is to go with a 401(k) scheme for making a regular investment. It is usually provided at organizations by deducting this contribution from the salary of their employees each month.
ETFs, Securities and Mutual Funds
Another way is to individually invest in such a scheme by taking up a systematic investment plan (SIP). For this purpose, one can invest in mutual funds, exchange-traded funds (ETFs) or securities.
To adopt this method of dollar-cost averaging, the investor can follow the given process:
- Determine a fixed amount of your regular income which you want to invest.
- Next, you need to ascertain the time interval at which you want to invest, whether monthly, quarterly, yearly; or even daily or weekly.
- Then you have to clear out your investment objective in the long-term and also the time period of accomplishing the same.
- Now, you can take the help of a broker or investment advisor to know all possible investment options which match your investment goal
- Select the most appropriate mutual funds, securities or ETFs; start investing; and be consistent.
- Lastly, keep an eye on your portfolio and rebalance it in the meanwhile, if necessary.
Calculation of Dollar-Cost Averaging
The dollar-cost average price is the numerical mean of the different fund values over the given intervals.
It can be simply computed using the below stated average calculation formula:
The total number of shares bought is the summation of the units acquired at different periods.
The acquisition of new shares always adds up to the previously owned units to provide the total number of shares owned. It is at last equal to the total number of shares bought.
At the end of the term or at the time of withdrawal, profit or loss on the overall investment can be determined with the application of the following formula:
Example
To better explain the calculation of profit or loss of the investment through dollar-cost averaging, let us take the following illustration:
| Investment Date | ABC Fund (Unit Price in $) | Contribution (in $) | Shares Purchased(in Units) | Shares Owned (in Units) | Total Value (in $) |
|---|---|---|---|---|---|
| August 5, 2019 | 10.00 | 100 | 10.00 | 10.00 | 100.00 |
| September 5, 2019 | 11.50 | 100 | 8.70 | 18.70 | 215.05 |
| October 5, 2019 | 9.85 | 100 | 10.15 | 28.85 | 284.17 |
| November 5, 2019 | 9.35 | 100 | 10.70 | 39.55 | 369.79 |
| December 5, 2019 | 10.75 | 100 | 9.30 | 48.85 | 525.14 |
| Dollar-Cost Average = $10.29 | Total Contribution = $500 | Total Shares Purchased = 48.85 Units | Investment Value = $525.14 | ||
| Profit | $25.14 |
In the above table, it is clearly stated that the investor made a profit of $25.14 on five months of investment.
However, if the investor would have pooled in all the sum i.e., $500 as a lump sum on November 5, 2019; buying 53.48 units @ $9.35 per unit would have yielded him a profit of $74.87 and 4.63 units more.
On the other hand, if the same $500 was invested on September 5, 2019, the investor would have made a loss of $32.61 and holding 5.37 units less, by purchasing 43.48 units @ $11.50 per unit.
Thus, by using the dollar-cost averaging, the investor had mitigated the risk of fluctuating stock price and still made a fair gain.
Dollar-Cost Averaging vs Lump Sum
Dollar-cost averaging is putting a definite sum (though small) in a certain financial instrument or its combination at fixed time intervals without being conscious of the investment price on the due date.
On the contrary, to invest at once getting all the asset units at a single price to benefit from timing the market fluctuation is called lump-sum investing.
The table below distinguishes dollar-cost averaging from lump-sum investing:
| Basis | Dollar-Cost Averaging | Lump Sum Investing |
|---|---|---|
| Aim | Counteracting short-term market volatility | Making a huge gain |
| Investment Frequency | Regular intervals | All at once |
| Sum Contributed | Small | Large |
| Timing the Market | No | Yes |
| Disciplined Process | Yes | No |
| Risk Involved | Low | High |
| Area of Risk | Holding while markets are low | Falsely timing the market |
| Beneficial to | Small investors | Market players |
Now, its completely up to you which one to select from the above two options. However please bear in mind your disposable income, present financial needs, risk-bearing capacity and investing goals before making a choice.
Benefits of Dollar-Cost Averaging
Dollar-cost averaging is not just a savings option, instead, it is a wealth creation mechanism for the investors. Let us discuss its multiple pros below:
Eliminates Uncertainty: One of the biggest advantages of DCA is that it reduces the risk of a volatile market, where timing the market may be highly detrimental.
Takes Advantage of Odds: When the market or stock performance is unfavourable, the investor can still gain through DCA, by availing more units at a discounted price.
Initiates Progressive Savings: It helps the small investors and individuals to accumulate wealth by consistently contributing to the securities for an extended period.
Fulfils Long-term Investment Goals: Savings can provide only a handful amount which is not sufficient for bigger life goals. DCA is a prominent way of realising such future aim.
Boon for Small Investors: The middle-class people cannot contribute a huge sum at once. Therefore, DCA is a benevolent opportunity for them to build up their future.
Discourages Emotional Impact: When a fixed sum is automatically deducted on the due date, the investors cannot be influenced by emotions like greediness, fear, excitement, etc to take investment decisions.
Disadvantages of Dollar-Cost Averaging
This method may not be always profitable for beginners. Thus, we should be aware of the following shortcomings of the DCA strategy:
Let Go Lump Sum Investing Gains
When the investors have a limited sum to invest, going for DCA means bearing the opportunity cost of leaving the lump sum investing option.
Involves Trading Cost
Obviously, the investors need to pay for the brokers’ fees, investment advisor’s commission and other charges while making investments. Such cost increases if the investment intervals are short.
Progressive Shares means Fewer Units
We cannot overlook the fact that as the security prices hike up with time, while the investment amount being the same, means the investors would be getting fewer units in future.
Requires Reallocation and Re-balancing
The investment portfolio requires constant monitoring. If the portfolio is not rebalanced by reallocating the funds into better securities, the investor may land up making an inadequate yield.
Does Dollar-Cost Averaging really work?
Now when you know how to go about it, you must be in dilemma that is it a good option or not.
DCA is no doubt one of the best ways to minimizing the risk of market volatility. It has made billions for some of the sincere investors like Warren Buffet. Also, it has fulfilled the retirement dreams of many other investors.
Now let us have a look over some of the common mistakes the investors make while going for dollar-cost averaging:
Sometimes, the investors fail to rebalance their investment portfolio when the present combination of assets may not fulfil future expectations, making it inefficient.
People who are bad with savings, do not invest consistently for a long period. Also, many people have the habit of withdrawing funds frequently neglecting the purpose of DCA.
The investors usually neglect the cost they pay for making the investments. It includes brokerage, fees, taxes and other trading costs. Thus, they land up yielding noticeably lower sum than they were expecting.
Dollar-cost averaging provide superior results only when the investors start contributing for it in their early years. Being too late to invest is a major mistake done by many people.
Investing a huge sum at long intervals, perhaps a year discourages the purpose of dollar-cost averaging. Therefore, people should break such contributions into the smaller sum, and shorten the intervals, say investing monthly or quarterly to get maximum benefit.
Many a time, when the markets or the stock is facing a tough time, the investors fear that they are investing in the wrong place.
This should indeed be taken positively, as when the conditions will improve, they would probably have a good lot of shares bought at an outstanding price.
Conclusion
Nevertheless, we should keep in mind our financial position and disposable income, before going for any kind of investment.
In the present scenario, where the market is highly unpredictable and volatile, DCA can be taken as a safer option.