Dollar Cost Averaging or not?
There are multiple ways of investing. One of the more passive ways is known as dollar cost averaging.
Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset’s price and at regular intervals; in effect, this strategy removes much of the detailed work of attempting to time the market in order to make purchases of equities at the best prices.
Extracted from Investopedia
Minus all the sophistication of what’s written up there, it means we put a fixed amount daily/monthly/yearly into a certain investment so that we average out our buy-in price.
It’s like gardening where you will need to tend to the plants regularly and conscientiously in hopes that it will grow well.
Dollar Cost Averaging Illustration
As an example: Let’s say we’re buying into a Real Estate Investment Trust (REIT) counter on any market. Why? Because it gives steady dividend, in most cases, and that’s why it’s a good place to exercise Dollar Cost Averaging.
You can learn more about REITs at No Money Lah’s post.
I’d allocate RM500 per month to contribute to REIT 1. Every month I would diligently buy up RM500 worth of shares in REIT 1.
I want to present 2 scenarios here.
If the prices go up monthly by 10c
| Amount Invested | Cumulative Investment | Price | Investment Value | % Gain | |
|---|---|---|---|---|---|
| Month 1 | 500 | 500 | 1 | 500 | – |
| Month 2 | 500 | 1,000 | 1.10 | 1,050 | 5% |
| Month 3 | 500 | 1,500 | 1.20 | 1,646 | 10% |
| Month 4 | 500 | 2,000 | 1.30 | 2,283 | 14% |
| Month 5 | 500 | 2,500 | 1.40 | 2,958 | 18% |
| Month 6 | 500 | 3,000 | 1.50 | 3,670 | 22% |
If the prices go down monthly by 10c
| Amount Invested | Cumulative Investment | Price | Investment Value | % Loss | |
|---|---|---|---|---|---|
| Month 1 | 500 | 500 | 1 | 500 | – |
| Month 2 | 500 | 1,000 | 0.90 | 950 | 5% |
| Month 3 | 500 | 1,500 | 0.80 | 1,345 | 10% |
| Month 4 | 500 | 2,000 | 0.70 | 1,677 | 16% |
| Month 5 | 500 | 2,500 | 0.60 | 1,937 | 23% |
| Month 6 | 500 | 3,000 | 0.50 | 2,114 | 30% |
Can you see that?
The good & the not so good
As you can see in the illustration above, with a 50% increase / decrease in the stock price by month 6, the total returns / losses is reduced.
Yes, it is a double edged sword. We minimise our loss hopefully when it rebounds we will get more returns. However, we also lose the full upside if the stock goes up.
The other potential risk here is that in most Dollar Cost Averaging mechanism, we set a fixed time in a month to invest that sum – month end / when salary is in / start of the month / etc. The issue here is that we could be so unlucky that every time it is time to invest, it is at the higher price point for the month. That sucks… but luck does play a part.
Then why do people recommend dollar cost averaging? If I were to guess, it’s because it gives people the “sense of calmness” that we won’t need to worry about the market’s ups and downs and will just periodically invest a sum like clockwork.
I must add on that this was also popularised by mutual funds. At least, that’s where I heard the most of, but I’m skeptical as they are partially motivated by the sales charge.
Which brings me to… the case of commissions that we’re paying for any investments (depending on the amount). By doing a monthly dollar cost averaging investment, we’re technically paying 12 times a year at the highest commission rate (in most cases due to smaller investment size).
With that said, I do think there are uses for Dollar Cost Averaging.
What I use dollar cost averaging on?
My journey on dollar cost averaging began with mutual funds. I’ve tried dollar cost averaging via direct debit on mutual funds a long time ago. The market was going up monthly and hence my cost was averaging up. Then one fine day the market decided to take a dip. That’s when I realised that the amount I’ve invested thus far actually suffered a much bigger loss due to my average cost being higher. Hence, I stopped doing dollar cost averaging. As a matter of fact, I have stopped putting more money into mutual funds altogether (partially due to the agent’s incompetence) as evident in my portfolio.
Other asset that I have used dollar cost averaging on is bond funds via robo-advisors because their prices rarely fluctuate too much.
Currently the only other investment asset that I use Dollar Cost Averaging on is Gold via HelloGold due to their Smart Saver plan. They promote that they would purchase gold daily at the lowest price, which takes away the risk of buying in at the monthly high price. Furthermore, Gold is at an all-time high when I started investing in small sums, so I wanted to ensure that:
- I start investing
- The investment is done only with small sums since it is at all-time high price levels
- I am prepared for the Smart Saver to “save” me from the downward movement by averaging down
Speaking of average down…
Average Down vs Dollar Cost Averaging
What I prefer is to use the concept of “Average Down” in my investments.
We can’t control how the market moves and whether the prices will go up or down after we invest. What we can control is how and when we invest.
My approach is to always keep a basket of potential stocks in my watchlist as mentioned in my Step 3 on investing steps 101. With this basket of stocks, I can then monitor where prices are heading. Rather than investing into a stock or any asset when the prices are up, I’d only invest when the prices fall to a target price.
When we do invest in a stock or asset, it is possible that the price will fall below our invested prices. This is where averaging down shines as it takes on the benefit of dollar cost averaging to minimise our losses and amplifies the profits via more investment in the particular asset. This is on the assumption that we are investing in a fundamentally strong asset whereby prices will eventually turn around. It may take years, though. I follow my defensive investment principles generally when I invest.
If prices were up above my invested price, then I’d only think about when to realise that investment into profits. I would seldom add on unless there is a particularly compelling reason to do so. I would scour my watchlist for other stocks to invest in instead.
This approach is obviously not too relevant for short term traders but can be beneficial to the long term investors.
But how about non-stock related investments?
Modified Dollar Cost Averaging
For assets such as robo-advisors, bond funds and gold, I do recommend the use of some form of dollar cost averaging. However, I would keep the monthly amount small.
Upfront I will invest a lump sum amount and when prices fall substantially, I will again average down with a lump sum amount.
Hence, I keep a close eye to the prices on these investments and a ready cash pile to go in when prices are right.
There you go
That’s my take on dollar cost averaging. I don’t use a straight up dollar cost averaging as I believe with some active management we could reap more benefits from our investments.
