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What is the dollar cost averaging investment strategy – and how can I use it?

By Louise Chan · September 02 2019
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Invest

What is the dollar cost averaging investment strategy – and how can I use it?

By Louise Chan
September 02 2019
Reading:
egg
egg
egg
Dollar cost averaging investment strategy

What is the dollar cost averaging investment strategy – and how can I use it?

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By Louise Chan · September 02 2019
Reading:
egg
egg
egg
Dollar cost averaging investment strategy

The dollar cost averaging (DCA) strategy is an approach investors use to spread out their exposure to market risks. DCA remains a valuable method for those who have reservations in committing a huge capital in the investment market as a lump sum.

The DCA strategy requires discipline and emotional control in order to follow an investment schedule despite price fluctuations—in hopes that the price averages out or gets closer to the lowest purchase price.

It is a long-term investment strategy that requires making additional investments at regular intervals for a fixed period – whether in fixed dollar amount or number of assets.

How to execute DCA

Making a long-term investment means you need to have a clear objective and make investment decisions that are aligned with your goals. This means you need to be aware of the portfolio’s potential gains  or losses and accept that these fluctuations can happen.

Here are the three steps to get started with the DCA strategy:

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Step 1: Review the intended investment’s performance
The  Australian Securities Exchange (ASX) website provides company information and annual financial reports. Access these when you do a quick background check to assess a company’s performance in spite of market volatility. 

The information can give you and potential investors an idea if the company’s performance can meet expectations despite market volatility – or if it’s better to shop around for another.

Step 2: Decide the amount and schedule of investment
Investors should decide whether they wish to commit purchasing investments based on its price or its volume for the duration of their intended investment.

An investor can commit to  purchasing an ‘x’ number of units or commit to a specific amount of money, according to the schedule. They can also commit to a fixed dollar amount of monthly or quarterly purchase for the duration of the investment.

Determine the investment duration and make an actual dollar or unit purchase commitment.  Set upper and lower limits to the prices you’re willing to purchase.

The goal of the DCA is to average out the cost of investment by purchasing whether the price is high or low. Purchasing declining stock or fewer units for a higher price with each transaction counters the DCA strategy.

Step 3: Maintain a consistent schedule
Consistency is the key ingredient when it comes to DCA and it is also what forces investors to separate their emotions from their money.

Use the DCA strategy means you need to follow each scheduled purchase regardless of the investment’s market price. Focusing on consistency! This can help drill discipline into you and remove the potential for greed- and fear-based reactions to the market movements.

Best time to use the dollar cost averaging strategy

Some finance experts point out that the DCA strategy does not always give the best returns compared to lump sum investments. 

The DCA strategy requires the right market conditions for your efforts to bear fruit. If market prices are rising, using the DCA strategy would result in owning fewer stocks with each transaction. This means smaller dividends to collect or fewer assets to liquidate in the future.

If market prices are falling, using the DCA strategy is beneficial because you will be able to purchase more shares when prices go down. However, you need to do due diligence to ensure that you’re not buying into a business that could possibly close down.

In the right conditions, the costs average out in the end.

Trend and timing

Dollar cost averaging is never about ‘timing the market’. Focusing on timing the market could decrease your investment strategy’s potential for success. Constantly monitoring market trends and daily price  fluctuations and waiting to invest when the market conditions are “right” are ‘timing the market’. 

The DCA strategy focuses on your ‘time in the market’ and it minimises loss from high prices in exchange for a larger volume of shares when prices are lower.  This avoids emotional decision-making stemming from market panic.

Remember that the stock market has the tendency to crash or perform poorly at least once every decade, but it also climbs back up and performs well after.

Why are trend and timing so important for DCA?
The dollar cost averaging strategy is all about averaging out your losses and gains in response to volatility so it’s important to know the market conditions—or at least your chosen investment’s performance—prior to jumping in. 

Consider Bob and Bill: both have $100,000 to invest in company ABC. But ABC executives were rumoured to be cutting costs at the expense of its employees. Still, they make their investments at the same time – when company ABC’s share price was at $20 per unit. The difference is that Bob made a lump sum investment while Bill decided to take the DCA approach and make equal quarterly investments.

At the beginning of their investments, Bob owns 5,000 company ABC shares while Bill has 1,250 units. In the next quarter, two executives were fired after they were found guilty of workplace malpractice. The company’s value plummeted to $12 per share, but Bill still made the purchase and ended with 2,083.33 shares.

The company replaced the two executives and began to turn things around for the workers and business. With their efforts the company’s share price rose to $15 by the 3rd quarter. Bill buys another $25,000 worth of shares and received 1,666.67 units. The good results kept piling up and, by the end of the year, company ABC’s share price was at $22 per unit, which gave Bill another 1,136 units for his $25,000.

If Bob decided to keep his investment, his 5,000 shares purchased at $20 per share would be worth $110,000. However, Bill had accumulated 6,136 shares valued at $134,992 in the same period – and with the average price of $17.25 using the DCA approach!

Now imagine the opposite wherein company ABC has been consistently performing well and recently expanded overseas. Since it could very well dominate the market Bob and Bill became attracted to the company’s shares. ABC’s share prices during Bill’s quarterly investment were $20, $18, $23 and $27.

Bob’s lump sum and 5,000 shares would be worth $135,000 after 12 months— what about Bill?

The share prices allowed Bill to purchase 1,250 units in the 1st quarter, 1,388.89 shares in the 2nd, 1,086.96 units in the 3rd and 925.93 shares in the 4th quarter. By the end of the period, Bill would own a total of 4,651.78 shares valued at $125,598.06, but purchased at an average price of $22.

Bill’s investment still loses out to Bob’s both in number of shares owned and total value of his portfolio because his timing was off.

Remember, however, that DCA is most ideal for long term investments (5 years and longer) so the examples above which only cover a 12-month period are simply for illustration purposes. 

Dollar cost averaging is not always the best approach— but it’s a start

DCA is not a strategy that guarantees the highest returns, but it gives the opportunity to minimise the risks associated with volatile market conditions. Its disciplined, formulaic approach prevents knee-jerk reactions to price fluctuations. It forces you to focus on your investment goals instead.

It’s an approach that is best suited to investors who would rather dip their toe in the investment market and decrease the risk of mistiming their investment by taking the plunge.

Seek the advice of a professional before using the DCA strategy according to your specific circumstance.

What is the dollar cost averaging investment strategy – and how can I use it?
Dollar cost averaging investment strategy
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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

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About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

Join The Nest Egg community

We Translate Complicated Financial Jargon Into Easy-To-Understand Information For Australians

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