Dollar Cost Averaging refers to an investment tactic where a given amount is allocated over a period of time consistently, regardless of the price of the security.
Dollar cost averaging aims to lower the cost of acquisition of a security by making steady purchases on a periodic basis.
This strategy aids in eliminating guesswork and promotes responsible long-term investing decisions, thereby minimizing rash, irrational decisions.
The underlying premise behind dollar cost averaging is to avoid the temptation to catch the absolute bottom or refrain from investing at the highs in a given market.
Investor psychology swings between greed and fear as they experience market volatility, but by using rules-based systematic asset allocation decisions, they can step aside from such emotional tugs and make rational decisions.
Example of Dollar Cost Averaging
Investors can benefit from dollar cost averaging as it is difficult to catch the lowest point on a price chart, but by strategically deploying capital in a stretch of time, they can increase the odds of ensuring a favourable entry into the investment.
Here is an example of investing in Lithium Americas (LAC) for an investor that allocates 7.2% of their capital consistently every week vs a 100% lump sum investment on a given date.
For simplicity purposes, let’s assume she starts investing from January 3rd and invests at the closing price on Monday at the beginning of each week.
The lump-sum portfolio allocated $10,000 on January 3rd at an average price of $39.23 while the DCA portfolio acquired its LAC position over the course of the next 14 weeks buying $714 ($10,000/14 weeks) worth of stock every Monday.
During the end of the period, the DCA portfolio has accumulated 4.6% of incremental performance.
|Date||LAC Price ($)||Lump-sum Portfolio ($)||DCA Portfolio Value ($)|
Benefits of Dollar Cost Averaging
1. Rules-Based Investing
Investors can avoid the emotional pitfalls of catching the lows on a stock chart by buying dips blindly and prevent sizing inappropriately into a position by buying too much stock at once.
2. Creates a Saving Habit
When an investor tops up the portfolio at a given interval for a predefined amount they are less likely to spend this money as it’s earmarked for investment purposes and not for discretionary spending.
3. Reduces Cost of Acquisition
By following a DCA approach, investors are more likely to buy securities at a cheaper price rather than lump-sum investing as prices often move randomly in the short run, so the investor benefits from short-term price volatility to pick up shares at a cheaper cost, thereby reducing the cost of acquisition.
Drawbacks of Dollar Cost Averaging
1. Logistics of Execution
The investor has to keep a schedule for purchases to be made of different companies and allocate investing capital on a regular basis based on that schedule.
Unless investors are disciplined and fairly active in the marketplace, they can fall out of a routine and may miss out on the targets set to acquire the desired number of shares.
2. Costs of Execution
As the investor buys smaller quantities on a regular basis, they will incur higher transaction costs such as fees, commission and slippage on these incremental purchases, which would have been avoided in the case of a lump sum investing approach.
3. Net Losing Strategy
In a runaway bull market, dollar cost averaging will be a losing strategy when compared to lump sum investments made initially.
Did You Know?
Paul Tudor Jones had a sign above his monitor that stated: “Losers Average Losers” reminding him to press winning trades and cut losers. This goes against the wisdom of dollar cost averaging and tweaks the approach which suits more active market participants.
Dollar Cost Averaging vs Lump Sum Investing
Most investors will benefit from dollar cost averaging in the short run with market volatility.
However, if we take a step back, markets have trended up over time historically.
In periods of market turbulence, it is important for investors to keep an eye on long-term investing goals and objectives and the least they should do is hold on to existing investments, if not add to those holdings.
It’s important to have high conviction in the portfolio holdings that are meant to perform over a long period of time and shouldn’t be composed of meme stocks that might be flavour du jour.
Dollar Cost Averaging for Crypto
Digital assets have gained widespread adoption across the spectrum of the investor community.
While there is froth in these markets with aggressive speculation, there might be a case for lump sum investing depending on your knowledge base of the market and fundamentals of certain crypto assets so that you can have maximum exposure to upward price appreciation.
However, the average investor, without any significant advantage should be aware of the risks entailed in these products and may be better suited to get exposure to the asset class on a steady basis using dollar cost averaging in order to smoothen out the cost of acquisition.
Frequently Asked Questions
- Is dollar cost averaging a good idea?
DCA can be a good principle as it leads investors to follow a system and avoid investing using emotions to dictate buy and sell decisions. However, there are drawbacks with such a simplistic system as it fails to discern between a bull, bear or sideways market and will fail to optimize for the best strategy in each market. Having said that, any particular categorization of a market can be done on a hindsight basis, so in the present, DCA will not disadvantage you as the benefits are worth the trade-offs.
- What is the best way to dollar cost average?
Dollar Cost Averaging serves best in bear markets as volatility picks up and attractive buying opportunities may exist. But since markets might be selling off, it can be hard to pin the exact bottom. Like history has shown numerous times though, it pays off to bite the bullet and start picking away at companies that are going to stand the downturn or slow down and will participate in the ensuing recovery.
- What does DCA mean in Crypto?
Crypto like any other asset class expresses volatility and has periods of pullbacks where selling begets more selling. During these times, it can be useful to step back and do a thorough, complete analysis of digital assets that should be bought despite the correction as it will mean your cost of acquisition will sit smack in the middle and not be skewed by the extremes of the price range swapping out a speculation or trading mindset for a more long-term investor mindset.