Do you often allot a lumpsum amount to your investments and then realize you were too hasty to place your bets after noticing the price of your investment reaching a new low?
A few weeks ago, when Facebook(FB) hit a new high for 2018, peaking at $217.5, the positive sentiment among investors resulted in some irrational decisions. One of my friends was among the many who purchased the stock at $215, only to realize a few hours later that the stock had fallen over 20% in after market hours. The reasons for this sudden decline attributed to reduced active users, low revenue and a hit from Europe’s new privacy laws, and made it the biggest single day loss in history. What can be done when you realize your money won’t be making you any money for an extended period of time?
Here comes the idea of Dollar Cost Averaging(DCA), also termed as a Systematic Investment Plan(SIP), which allows investors to buy a fixed amount of a particular investment on a regular schedule, irrespective of the share price. This amount can be contributed towards individual stocks, mutual funds or ETF’s and serves as a great risk management tool for investors. Why use financial jargon when we can use simple examples?
Let’s say you wish to purchase the stock for a company A, currently priced at $100. You have been carefully reviewing the company fundamentals and are confident the company is on its way to greater growth and success. You have $4,000 in your savings and decide to purchase 40 shares of this stock and in a month this price has now reduced to $90. You suddenly question your methods of investing and realize you have put all your savings and lost $400 in a single month!
Instead, you come to this blog and learn how to use the idea of dollar cost averaging towards your advantage. You schedule a monthly investment of $1,000 towards the investment of your choice. Here’s how your investments would look if this stock followed the price pattern for the next 4 months
Month 1: $100
Month 2: $90
Month 3: $95
Month 4: $105
Number of Shares purchased in Month 1 = 1000/100 = 10 shares.
Similarly shares purchased in the following months can be calculated and we get 11.11, 10.52 and 9.52 shares respectively for each month. The total number of shares purchased over a period of 4 months is now equal to 41 at an average price of 97.5. Instead of purchasing the stock in lumpsum at $100, with DCA you have reduced the average stock price to 97.5!
If you decide to sell in the fourth month at $105, you would make $2.5 more on each stock you own, yielding $100 more in profits! Sounds like you hit the magical formula to achieving success in the stock market? Let us clearly understand the advantages and disadvantages with this strategy.
1. BEST STRATEGY FOR NEWBIES
Most beginners are uncertain before investing in the stock market and are afraid to invest regardless of the price of the stock. DCA offers the perfect starting point to investing and allows you to take control of your investments. The distribution of purchases allows you to carefully identify opportunities and even allow diversification of investments. A lumpsum investment often causes immense pressure for beginners and can leave one disappointed and weary of investment if they fail. A small percentage of your paycheck allotted to your choice of stock of mutual fund each month could yield high returns over the long term.
2. HOLDING FOR THE LONG TERM
Holding investments for the long term is key to value investing. DCA allows investors to hold on to their investments for a longer period of time because of the averaging factor. As we saw in our example where the average price was reduced to 97.5, this strategy can allow investors to hold on to good company stock without hastily selling good investments due to market sentiments. If you are thorough with company fundamentals and understand that your investments are to yield returns for the long term, DCA will provide the necessary support without much effort.
And now the disadvantages…
DCA can be used as a great risk management tool, but it can also lead to missed opportunities. Using our example from before, if the investor purchased his stock at the price of $90 in the second month, he could earn more profits as opposed to averaging it at 97.5. However, nobody can time the market, and as I have said before, any person who claims the ability to time the market, is a LIAR!
Another aspect to look at with DCA is the associated costs or fees. Because you are buying into the market each month, every trade will have an associated cost. These could add up to high amounts and can vary by brokerage, and you must ensure your selection does not overcharge you for your investments.
Investments in the stock market must be aimed towards long term growth as opposed to making short term gains, which is where DCA can offer some aversion to the risk associated with investments. If you wish to use this as a starting point, you may also want to read Start investing with Mutual Funds – Your guide to Diversification
Be Frugal, Be Smart, Be Rich!