I’m sure we have all heard that putting away money regularly is key to building a successful portfolio and that trying to time the market is simply a loser’s game. The dollar-cost averaging strategy helps an investor mitigate that risk by putting a fixed amount of money in a stock or fund over time, regardless of fluctuations. It is likely that you are employing this strategy right now if you own a 401K or Roth IRA account to which you contribute at regular intervals.
This strategy is geared towards retail investors who have little to no knowledge of the market and don’t have the time to create their own valuations, allowing them to minimize risk over time by investing in both bear and bull markets.
Let’s look at an example – assuming we receive $1,500 and want to invest the sum in Company X, which trades at $50 a share.
If we decided to invest the sum all at once in a lump-sum form we will receive 30 shares. The problem remains that we don’t know if we are getting a good deal. If Company X has a positive quarter in terms of earnings, and the share price increases, then of course this would be a good buy. However, if Company X is at its peak and the price falls from here the share will lose immense amounts of value, and we will lose money. Hence we are taking a risk by buying all of the shares at once.
We can reduce this risk using dollar-cost averaging by purchasing $500 of Company X shares every month at the price that it is quoted on the first trading day of the month. In the first interval we receive 10 shares at $50, however next month the price drops to $10, meaning we can now take advantage of a discount opportunity and have 50 shares. However, in year 3 the share soars at $100, meaning we receive only 5 shares.
|Sum Invested||Market Price||Shares Received|
Here the average price per share is around $23, a major discount from the earlier $50 per share, lump-sum.
As simple as this method may be, it’s a very strategic way to invest; when you invest in times where the market is down, the average cost per share in your portfolio decreases over time. Many investors consider dollar-cost averaging as another means of diversification as in theory you are purchasing the shares at different price levels.
This strategy is often described as too passive, as it causes one to lose out in times where money was to be made. Many famous investors say that most retail investors who employ dollar-cost averaging make returns that are inferior to that of funds like the S&P 500 and suggest that alternative strategies such as Momentum Investing and Expectations Investing should be employed to produce excess returns.
Now let’s assume we invested our $1,500, lump-sum, and purchased the shares when prices were low at $10 and received 150 shares. This is already a lot more than the 65 shares received with dollar-cost averaging. In this scenario, we would make significantly more money. Let’s assume the price of Company X reaches $75 next year and we sell. With dollar-cost averaging, we would make $3,375 compared to the $9,750 made lump-sum.
|Sum Invested Totally||Shares Owned||Value of Shares||Profit|
|$1,500 – Lump-Sum||150||$11,250||$9750|
|$1,500 – DCA*||65||$4,875||$3375|
*DCA – Dollar Cost Averaging
As much as making a lump-sum return is more rewarding, it is difficult to predict when the market will swing. Moreover, timing the market has always been a loser’s game. A recent study by the Yale School of Management shows that only 1 in 14,500,000 investors in the past decade were able to effectively time the market and make returns superior to the S&P 500 year on year
In order to benefit most from dollar-cost averaging, it may be beneficial to automate the process to reduce emotional effects. Furthermore, I suggest placing the money in an account that is tax-exempt, like the Roth IRA, to maximize the net gain made. Also, to be able to keep up with the investing schedule, use effective intervals for putting money into your chosen security.