What is dollar-cost averaging (DCA)?
Dollar-cost averaging is a simple strategy any investor can use to accumulate large sums of money in the stock market.
It’s a consistent investment strategy with many benefits. And, It’s the critical strategy most passive investors use on their journey to financial independence. (myself included)
Even though investing is simple, when you first start, you’ll have to contend with the emotional factor of watching your portfolio go down from time to time.
Dollar-cost averaging helps to smooth out the volatility of your portfolio. And at the same time smooth out your emotions and learn to ride the ups and downs of the stock market.
Dollar-cost averaging (DCA)
How it works.
You pick any period of time. It could be every week, every two weeks, once a month or even every 6 months. Just select the time interval and stick to that. You also don’t have to pick any of these time periods you could choose 3 weeks or even 6 weeks. The idea is to select a consistent time interval that you’re comfortable with.
Once you’ve picked the time interval, you’ll need to decide upon the set amount of money you’ll invest at that time period. For example, you can afford $300 every single month. So, every single month you invest $300 into a stock, ETF or LIC.
Like clockwork, you just keep at it. It doesn’t matter whether the markets up or down. You just keep going, adding $300 every single month. The eventual goal from this is you’ll buy more when prices are low and less when prices are high, ultimately you buy enough at lower prices your average purchase price will stay lower than the market price.
There’s no timing the market, and you’re less detached emotionally from market movements because you know exactly what you need to do. It’s a rock-solid plan, and as they say… time in the market is better than timing the market.
To show you how it works, I’ve made up a test example for VAS. The ETF in Australia that tracks the ASX300 index. These were just some of the prices it traded at during 2019. I’ve rounded off the share prices for simplicity.
The table reads, I invested an initial $500 (that’s the minimum entry to buy stocks in Australia… easy barrier to admission or what!) after that I put in $300 a month. Each time I purchased, you can see the number of shares I owned increases.
The results for the test are located at the bottom of the table. At the end of the year, the total invested (amount spent) would have been $3,800. Total shares purchased would have been 47. From there, I work out what the average purchase price would have been.
You’ll also notice, depending on the price I paid I would either buy more or less. At the end of December 2019 (assuming the current trading price was $90 a share) the results were my average purchase price was $80.55 a share, giving me a profit of $445.80 or roughly 12% gain.
Remember, no stress just a consistent investment strategy.
Side note: This is just an example to show how DCA works. In the real world, I would have spent $120 on trading fees, which would hurt these returns. I would have also received distribution payments which would have increased profits.
There’s a reason Warren Buffet says you need the right temperament to invest. If the market drops like a brick or sells off, and you get scared, fearful and act irrationally by selling your shares as they’re going down in price, then you’ll end up with mounting losses and no progress.
The good news is you can learn this temperament, and approach investing with the correct mindset.
Everyone has to go through learning this about themselves. Unless you’re taught the correct way to think about investing and losses to begin with, (which is what this blogs for) you’ll feel nervous when the markets are selling off.
For perspective on how far I’ve come from since that loss selling fearful investor. During the stock market crash from Coronavirus, my portfolio was $15k in the red. For some investors, that’s chump change. But to my fiance and me, that’s still a lot of my money, and it was a 30% paper loss of our net worth. However, we didn’t sell into that paper loss. We stuck to our strategy, and now we’re only $500 in the red. This is from consistently investing during the crash, and the market rebounding.
Dollar-Cost Averaging and Psychology
This is where dollar-cost averaging (DCA) will help your psychology and learning to ride the waves of volatility.
If you were to dump a lump sum into the market with no prior experience, you’d get those nerves up when volatility kicks in. You’ve put a vast majority of your wealth into the market and now it looks to be evaporating as the market declines.
You get the picture. With no prior market experience, there’s a high chance you might get fearful as the market sells off.
But, say if you were running a dollar-cost averaging system you could learn to walk before you run. You’re adding as you’re gaining experience in the market, feeling out the volatility and the movement of the market. Buying more into the sell-off creates this mental toughness and helps your ability to take action in times of stress.
Each time you ride out a market decline, you’ll become a little more mentally resilient. You’ll eventually get to the point where you’ll look forward to those days the market sells off. Because you know your money will buy you more at lower prices and help you reach your goals faster.
I like being transparent at the same time, and it’s worth mentioning that some investors believe this strategy isn’t as good as it’s made out to be.
They believe lump-sum investing works better, there have been studies done on what happens with lump-sum investing and how it’s performed better. I’ve seen them, and I can’t deny that the overall results look better.
However, from my perspective for the average investor or someone learning to invest, dollar cost averaging works better.
The results might be slightly worse off from using DCA. But, from a psychological standpoint it allows investors to get into the market with some confidence, and learn more about themselves and the market at their own pace.
With investing, the psychological perspective can’t be overstated. If this strategy helps you overcome your emotions then I believe it’s better then lump-sum investing.
As with all things investing it’s up to the individual and what they prefer. You’re the one that needs to choose between using a Dollar Cost Averaging or lump-sum system.
I myself like dollar-cost averaging better, due to the unforeseen mental benefits it can give to an investor. I wouldn’t care if I’m giving up 1% or so in gains by using this system.
The mental side of investing is just as crucial as executing the strategy. And I feel using DCA is a way to learn, while not putting too much of your hard-earned loot at risk. Run the DCA system for 5 years, reinvest the dividends and you’ll be surprised at much your money has grown.
What do you think, do you prefer to run a lump- sum or dollar cost averaging system? Let me know in the comments below