Did you ever struggle to keep your emotions under control while investing? Did you sell stocks when they went low because someone was telling that the market is going to crash now? Or did you buy new stocks because you’ve listened to a market analyst who said you need to get on the train?
You may have lost some money because you stopped or started investing at the wrong time.
Today, I will tell you about a technique that helps you to minimize that risk. It won’t pick useful stocks for you, but it will help you to keep your emotions under control.
I’m talking about Dollar-Cost Averaging. I want to add a short disclaimer here. This technique doesn’t work on all investing strategies and is more recommended for the beginner or average investor. Intermediate investors will probably know how much they want to pay for a certain security and with that won’t find any value in it.
With that said, let’s dive into DCA.
What is Dollar-Cost Averaging?
Dollar-Cost Averaging has 4 requirements. You are buying…
- exactly the same securities (e.g. Apple shares)…
- with the same amount of money (e.g. $500)…
- in regular intervals (e.g. monthly)…
- regardless of its share price.
What’s great about this technique is, is that you don’t have to time the market as you will always pay the average price over the long haul.
I like examples and I have one for you.
Let’s assume you have set aside $100 to buy stocks each and every month. You like Vanguards index funds and so you want to buy Vanguard total stock market index fund (VTSMX) shares. You pick the 15th of every month to buy those.
Note: The price and changes in the price are totally arbitrary. They have nothing to do with the real price and performance of VTSMX. Also, this is no recommendation that this stock performs very well or the opposite. I just used it to make it a little bit more realistic.
|Month||Price per share||# of purchased shares|
You see, every month, you spend $100 and buy some shares. However, in the first month, you can buy 10 shares as you need to pay $10/share. In month 6, you can only buy 8 shares as the price has been climbed to $12/share.
This means you buy many shares when the price is low and few if the price is high. This is actually what you want in investing.
Positive and negative effects of DCA on your investments
But why is this important?
You have paid $8.33 per share over the whole year. You can add the numbers of purchased shares for each of these 12 months and you will see that you now own 144 shares. Your investment was $1,200 (12 months * $100/month).
x = 1,200 / 144
x = 8.33
But still, why is this important?
If you would have bought all of the shares in the first month with your $1,200, you would only own 120 shares. With Dollar-Cost Averaging you have 144 shares!
At the beginning of the year, one share was traded for $10. In month 12 the value of one share is $11. This means without DCA you would have turned your initial investment of $1,200 to $1,320 (120 * 11). This is pretty good. However, with DCA you would have turned $1,200 to $1,584 (144 * 11). This is a difference of 22%!
Be careful! This also works the other way around. So if the stock performs well and the price per share is increasing over the whole year, you would have fewer shares with DCA as they are more expensive after month 1 and you would have performed better without DCA.
Benefits and disadvantages of Dollar-Cost Averaging
At the end of the year, you are paying the average price. This doesn’t mean that the average price is lower or higher compared to your starting point. I have already said, that DCA can be beneficial but also has its drawbacks.
The main benefits are:
- You can automate the process by just picking the stock/fund once and do you contributions monthly (you should check funds roughly every year).
- This also removes a part of your emotions. You buy the stock every month, so you don’t look if it’s up or down. This is very good as people tend to buy stocks when they are going up and selling them when they are going down. You want exactly the opposite.
- You don’t need to time the market and to guess when it goes up and down. Regardless what the price is, you just want to buy your shares each and every month.
- There is no need for a big lump sum investment. You can start with just a few dollars per month.
- You are limiting the risk of picking the wrong time to start.
- In a falling market, you will lose less money.
The disadvantages are:
- You have to pay fees for transactions every single month. They can add up pretty fast. With most brokers, you pay a fixed amount of money for every transaction. But you will have 12 instead of 1 per year.
- In a rising market, you will have smaller gains.
- It doesn’t work for all investing strategies.
When to consider Dollar-Cost Averaging?
As mentioned before, Dollar-Cost Averaging doesn’t work if your strategy is about picking stocks depending on their current price. For example, in value investing you look for undervalued companies. That means these companies are traded on a price below what they are actually worth. This can change on a daily or at least monthly basis. With such strategies, you have to manually pick sticks and look for the prices every single time. An automated process with DCA doesn’t work here.
If you know exactly what you are doing and know what price you want to pay per share, you won’t need DCA. Also, if you are a trader who frequently buys and sells stocks, you can’t make use of Dollar-Cost Averaging.
However, DCA makes sense, if you are an investor, who buys stocks for many years and the day-to-day-price is not very important to you. You don’t need a lump sum to start investing and you can start with a small monthly contribution and automate much of the process. For example, if you are investing in index funds, DCA can help you to limit the risk of a single investment at a bad time.
With Dollar-Cost Averaging you can easily reduce some emotional factors of investing by simply automating the process and buying the same stocks with the same amount of money in a regular interval. It’s a fast improvement for those who struggle to keep investing when the market drops and throw the money into the market when it rises.
With DCA you buy stocks even when the market is down and as Baron Rothschild, and later Warren Buffett said: ‘Buy when there’s blood in the streets, even if the blood is your own’.
What do you think about Dollar-Cost Averaging? Have you any experiences? Tell me, by leaving a comment below!