Dollar-Cost Averaging and why it’s useful

Dollar-cost averaging is based on the idea to invest smaller amounts after regular intervals. It helps the investors to remain safe from the adverse impacts of the price fluctuation in the market. Since all the available amount is not tied up as the investment hence, its exposure to the loss in case of market devaluation is limited.

The concept is based on the assumption that investing for a lump sum amount exposes the investor to greater risk as the pricing of the assets keeps changing in the market. However, if the investment is made in multiple periods, it’s not much risky, and return is expected in the longer run. However, the problem is that it assumes an increase in the value of the security/assets with time which is not always the case. So, believing in dollar-cost averaging can be dangerous and cause a loss if the situation is not monitored actively. For instance, it may be a time to sell and get cash from particular security as opposed to the working mechanism of the dollar cost averaging and keep making an investment after a regular period of time.

Why use dollar-cost averaging as an investment strategy

The following are some of the reasons that why an investor should opt for dollar-cost investing.

Emotional stability

The mechanical approach of dollar-cost investing eliminates the emotional component of pain from the decision-making process of your mind. Even if there is any loss on the investment, the mind does not look at the loss as a component of the transaction but considers it as some opportunity to invest and increase the worth as the assumption is that the value of the investment increases with time. So, the mind will think in a direction that more units of the investment can be bought with the same amount of funds in this period in comparison with the last period. So, there will be more potential for earnings in the future as the value of the investment portfolio increases with time. Hence, if you are a behavioral investor, dollar-cost averaging can be an excellent mode of investment for you.

Acts as a stabiliser of your investment

The investor may invest in a time when the market is just about to crash, which will lead to a massive loss for the investor as his/her exposure to this risk is higher. For instance, consider an investor heavily invested in the airline industry just before the appearance of the COVID-19 had to face massive loss as timings of the investment was not favorable although the industry is considered to be among the best profit generating industries.

So, there is a need to create gaps in the investment to avoid adverse timing, which is offered by the dollar-cost averaging.

Best for the long terms investors

Generally, it has been observed that the prices/value of the investment increases with time. So, when an investor has confirmed mind to invest for a longer time period, the DCA seems to be an excellent approach to the investment. The importance of applying DCA increases exponentially when the investment is made in the low volatile funds, as was shown in a study conducted by Israelsen (1999). This study was conducted on the 35 large equity funds, and it was found that DCA produced more returns for 19 of the funds.

The better option for the investors with regular earnings and investing mind

Sometimes, the investors do not have lump-sum payments but confirm in mind to make an investment. In this case, the dollar-cost averaging seems to be the only option available to the investor. Although, he/she can actively manage the prior investment portfolio.

The behavior of the investor plays an important role in the investment decision. For instance, it’s the greed and fear that motivate an investor to sell and purchase the security. For some investors, it’s difficult to bear the loss as it causes them a greater psychological problem because their mind is not ready to accept the loss as these people are the risk-averse. So, the DCA can be an excellent mode of investment for these types of investors.

Why you should opt for DCA (in the light of research conducted on real-life data)

In real life, we find multiple examples where the DCA mode of the investment has outweighed the lump sum investment – LSI. For instance,

The simple answer to the question of why DCA should be preferred over LSI is DCA helps to avoid massive losses. The research presented by the Vanguard concluded that in times of the down market, the losses reported by the DCA were lower. Specifically, the study highlighted that the decline with the lump sum investment was 22.4%, and for DCA, it was 17.6%. Hence, DCA can be an excellent approach to investment in times when the market falls. In other words, DCA helps to preserve the asset and save from the massive losses.

Further, the study conducted in 2012 by Vanguard also concluded that in the bearish market, when the LSI approach has produced the worst results, the DCA approach has looked better than average. The study further entails that DCA trails LSI about two-third of the time for the period under analysis. So, it can be an impressive policy to invest by way of DCA.

How you should use Dollar Cost Averaging

DCA is a very simple investment approach. You can set aside some specific amount of the money from your income every month/period and invest in some mutual funds or stocks. You just need to be consistent in making the investment every month. As per the theme of the DCA, there is no need to worry about the valuation of the investment portfolio as it is assumed to increase in the coming time. So, you just need to put money in the investment from time to time.

It’s important to note that the number of units purchased every month differs. So, if the price increases, the number of units purchased in the period decreases. On the other hand, if the price of the investment decreases, the number of units purchased increases.

Example of the dollar-cost averaging

Consider Mr X working at Alpha plc on the monthly salary of USD 10,000. Mr X has committed to invest the invest 10% of the salary in the mutual funds for each month. The approach of the investment is for the long term, and he does not focus on that how his funds are performing; instead gets USD 1,000 and invests in the funds as his history for the year 2020 is given below.

Months Fund’s index Monthly investment Units purchased Units owned Units value
January 100.000 1,000 10 10 1,000.000
February 125.000 1,000 8 18 2,250.000
March 250.000 1,000 4 22 5,500.000
April 166.667 1,000 6 28 4,666.667
May 125.000 1,000 8 36 4,500.000
June 125.000 1,000 8 44 5,500.000
July 83.333 1,000 12 56 4,666.667
August 111.111 1,000 9 65 7,222.222
September 125.000 1,000 8 73 9,125.000
October 142.857 1,000 7 80 11,428.571
November 166.667 1,000 6 86 14,333.333
December 200.000 1,000 5 91 18,200.000
Total 12,000 91 91

In a given case, the DCA approach has proved to be profitable for Mr X because the annual contribution amounts to USD 12,000 and the value of the funds owned by Mr X amounts to USD 18,200. Since the market has a value of the units or NAV has moved up in the period under consideration. Hence, Mr X has made a profit of USD 6,200 (18,200-12,000).

An important point to note is that the value of the unit has reached twice in December in comparison with January while profit is not double, it’s simply due to the fact that the purchase function was spread throughout the year and NAV kept fluctuating. However, there was more proportion of increase of the price as in all of the months the price index had increased except in July when NAV was below USD 100. So, the increase in the value of the NAV has resulted in the success of the DCA in the case of Mr.X.

Dollar-cost average vs. lump sum investment

DCA or Dollar-cost average is when a small amount is invested after some specific time. It does not take into account the valuation of the investment portfolio. On the other hand, lump-sum investments in when all of the amounts are invested at once to earn higher profits.

Extensive research has been carried out on the topic that of which investment strategy should be used. It has been found that there is no absolute answer to the questions. However, it is clear that DCA is more inclined to limit the exposure of investment to the loss.

Million-dollar advice

If you don’t have sound experience in investment and want to remain safe from the massive fluctuation of the investment value, the dollar-cost-averaging mode of the investment can be an excellent investing approach for you. However, if you deeply understand the active management of an investment portfolio, it can be a better option to maximize the return with a lump-sum investment. But, keep in mind that only the strategy that can protect you from losses is DCA.

Conclusion

The dollar cost average is when an investor invests small amounts in stocks or mutual funds after a regular period of time. This helps to limit the exposure of the investment to massive loss and provides a return in the long run. This strategy does not focus on the valuation of the stocks but a continuous investment as it’s based on the idea that investment will be fruitful in the long future. So, it’s focused on the behavioral aspects of the investor and frees them up from the psychological pain of the loss.

Different studies conducted on the topic have proved that investing by DCA has great stability in terms of protection from loss. Although, it may not be a prime strategy to generate profit.

Also Read What is a CFD?