Dollar cost averaging is a distinct investment technique.
As the name indicates, it is all about buying dollars and the art of averaging.
The basic trend is buying a large number of shares when the price is less.
You buy fewer shares when the price is higher.
In this way, you can average out the total cost of the investment.
Instead of scampering for a huge amount, you buy in tranches.
This means that investors regularly follow the dollar movement and buy.
However, you must remember that this does not limit risk exposure.
It is only a way to spread out the expenses over time.
This method does not guarantee that you won’t lose money.
It only helps you to spread out the cost comfortably.
You can call it more a strategy to create an investment pool.
Depending on your ability, you can invest a set amount every month.
Of course, the amount you invest depends on the final target and investment objective.
There is no set investment tool for dollar cost averaging.
Your portfolio could comprise of any investment tool from MFs to exchange-traded funds.
It is even possible to undertake dollar cost averaging on stocks.
So in this case, the investor identifies a source and makes meaningful investment regularly.
They do not have to worry too much about timing their investment.
The mathematics is quite simple.
The investment is spread out on ore shares when prices are lower.
How Dollar Cost Averaging Works
So what is the principle on which this strategy works?
This strategy in many ways is similar to a systematic investment plan.
You can buy chunks of shares at regular intervals.
So in many ways, it reduces your risk to a large extent.
The chances of your buying large number stocks at highs are much lesser.
Similarly, you do not completely miss out the troughs.
So it becomes a balanced opportunity to maximize gains.
Also, you do not have to keep waiting for the right opportunity.
At least regular investment will make sure you do not miss out big blips.
However, the point to note is you can assess your gains on a retrospective basis.
Only after an extended period, you can assess how much you gained.
The jury is out on whether it is the best strategy for all investments.
I would say that this strategy is more effective on handle volatility.
Supposing the price of a product sees wild swings, this is a simple approach to tackle it.
It makes sure that you can invest both at troughs and crests.
In case you are still wondering about the intricacies, here is a simpler explanation.
A Simple Representation of Dollar Cost Averaging
Let me explain this concept with an example.
Let’s say I have decided that I can spare $1000 every month.
Now every month the number of shares that I buy depends on the share price.
Let’s say that my investment was in this order for a year:
Jan @ $10/sh= 100 units
Feb @ $20/sh= 50 units
March @ $12.50= 80 units
April @ $25= 40 units
May @$16.67= 60 units
[email protected] $10= 100 units
July @ $23.81= 42 units
August @ $22= 45 units
September @ $20= 50 units
October @ $19= 52 shares
November @ $16.67= 60 units
December @ $10= 100 units
So at the end of the year, I spent $12000 and got 779 shares.
Though the price kept varying over the year, I spent an average $15.40 for these shares.
At the higher-end, the price went up to $25 also.
If I spent the same amount, I would get 480 shares at $25.
So, for the same amount, I got a relatively larger number of shares.
Therefore, the dollar cost averaging is the best way to get more value for money.
If you can’t spare the entire amount when prices are low, this is an easy option.
It helps you get the maximum value for your money.
So, despite spending much less every month, you are able to get more.
For serious investors, this offers a unique value creation option.
Why Is Dollar Cost Averaging Popular?
That brings us to the key topic, why does this strategy matter?
The fact that so many investors use it globally reflects the veracity of the strategy.
There are many reasons why this strategy appeals to a large mass of investors.
Ease to invest is undeniably the biggest reason why many are attracted.
It helps you take advantage of market trends without stretching yourself a lot.
You are investing in small chunks so even in terms of leverage, it is limited.
In that context, your relative risk is also limited.
Dollar cost averaging eliminates the need for time markets.
The investor can safely rely on average trends to determine the return prospects.
The overall stock performance becomes a more prominent indicator.
Investors don’t have to track stocks on a minute to minute basis.
They simply need to follow the broad trends.
Another reason why this is a popular method is that it gives you leeway to retreat.
Let’s use our old example, to understand this point better.
Suppose the stock or MF or ET you are investing in slides significantly.
How do you respond to that?
Suppose you had invested the entire $12000, you would be over-leveraged.
But when you have only $2000 or $3000, retracting becomes much simpler.
You can simply change your investment options.
Limited exposure at any given time also helps you diversify better.
It helps you in identifying options and further enhancing return prospects.
Instead of getting return from one product, you earn returns from a wide umbrella.
It leaves you with the scope to explore various investment options.
This directly increases the viability of investment opportunities.
Most astute investors consider this as a major advantage.
This enables you to set up wider investment target.
Better Approach to Tackle Volatility
If you set about listing the benefits of dollar cost averaging, there are many.
But one of the important ones is tackling volatility.
It offers you a unique opportunity to deal with volatility.
The unpredictability element is one of the biggest scourges of market investment.
This is where volatility stems from.
When the price rises suddenly, you feel you lost a profit opportunity.
When the price falls sharply, you are again between a devil and the deep sea.
But dollar-cost averaging comes to your rescue.
You can always be sure that if you have 10 units at the highest rate, you also have at least 10 at the lowest price.
This means that you have exposure at both ends of the range.
This decidedly reduces the overall volatility impact.
It is impossible to make sure every trade is perfect.
But this ensures that margin of error is considerably limited.
In a volatile condition, this can be the best protective shield for your investment.
Whether prices fall too sharply or there are wild swings, you risk exposure won’t be alarming.
Therefore, it acts as a cushion against volatility.
Even in case of losses, it helps you absorb the initial hit a lot better.
Scope to Invest Consistently
This is another major advantage of the dollar cost averaging strategy.
You are investing small amounts in regular tranches.
This means you will be able to invest a lot more than you envisaged.
For most salaried people, it is difficult to invest large sums in one go.
This method gives them the opportunity to invest regularly, albeit small sums.
Of course, over an extended period, your investment volume will also increase.
Moreover, you develop the habit to invest regularly.
In many types of asset classes, these consistent investments yield better returns.
Consistency also enhances the overall quality of investment.
You do not fall prey to one of the market moves.
Your investment remains solid, and you can enjoy compounded returns.
This is despite limiting your overall exposure.
Also, consistency helps you garner larger investment volumes.
When you invest the same sum over an extended period, you manage to bag larger units.
Think of the example we used.
If you had invested $12000 in one go, the maximum units were less than 500.
But by spreading out the investment, you managed to get close to 800 units of the same stock.
That is a huge gap.
You got almost 300 more shares for the same amount.
This is only possible by a consistent investment plan.
One of the many reasons why SIP is so popular is also this consistency.
The only difference here is you do not have a wealth manager looking after your funds.
You decide the investment portfolio and keep adding or subtracting from it.
That in many ways helps you take advantage of the benefits without losing flexibility.
Moreover, consistency also enables you to maintain focus.
A focused approach always improves the scope for better profits.
A More Profitable Strategy
The dollar cost averaging strategy is useful even in falling markets.
If you thought holding cash is better, think again.
Of course, holding cash means your risk is limited.
But at the same time, you should remember that it does not make your money work.
Let us take a hypothetical situation.
Imagine the market crash in 2008.
Let’s say A invests $100 in the market every day.
But another investor B sets aside $100 cash every day.
If you started investing from October 2007 and we compare the growth for both, the result is surprising.
Just chart the markets on the same day every year.
You will notice over these 10 years, the markets have risen
The result, your overall investment value is higher.
As a result, you will notice the cash in hand is much lower than the return an investor earned.
Despite the terrible fall, the DCA investment yields higher returns.
This is quite simple.
The market goes through a series of crests and trough.
With the DCA, you can take advantage of all these scenarios.
So you have bought shares at highs and lows.
Therefore, the average return is significantly broad-based.
It also helps work your money efficiently.
Hedge Your Retirement Savings
This is a major black hole in several investment portfolios.
Many salaried people tend to plan rather poorly for retirement.
Apart from the standard 401k or IRA, there is precious little.
In fact, a study indicated that almost 40% of American households have zero retirement savings.
This is a rather worrying situation.
In many ways, it highlights the lack of consciousness in maintaining a proper savings profile.
But dollar-cost averaging instills that savings habit.
With it, you can be sure of investing something every month.
So on a compounded basis; you will have a larger investment kitty.
Compared to a zero savings situation, this definitely will be far brighter.
Moreover, this approach helps you diversify the savings better.
It means though you are investing in small chunks, it is more sustainable.
You are able to invest a lot more efficiently and diversely.
So, the average investment profile for your retirement becomes promising.
You can expect a more sustained regular income flow with this method.
It will help you plan your retirement funding a lot more comprehensively.
In many ways, this will also give you the confidence of introducing various elements.
Tackling Fear & Emotion Better
I am sure; you have often heard that you must keep your emotion at bay while investing in markets.
However, in reality, that is hardly the case.
You tend to panic easily or buoyed by euphoria.
Both of these are extreme situations and can harm your investment significantly.
However, dollar cost averaging helps you tackle your emotions better.
You can be far more composed while you don’t get perturbed by volatile swings that easily.
You are better poised to deal with sudden price swings.
The regularity of investment also regulates your return expectations comprehensively.
So you can be more focused as well.
No Set Formula for Asset Allocation
However, you must understand that there is no pre-decided amount of investment.
Dollar cost averaging is never about preserving profit.
It is primarily about limiting loss.
So, you have to decide asset allocation very carefully.
It depends entirely on your risk appetite and the profit target that you have set.
You have to assess your own exposure levels.
This also means you need to assess your risk profile carefully.
Unlike SIP, you do not have a fund manager to maintain your account.
Though, you do not track asset classes tick by tick.
You still have to keep a watch on the overall trends.
For example, if your investment is recording loss in consecutive months, take the warning sign.
Given your limited exposure, it is much easier to recoup losses.
So, before you take the plunge, carefully make a list of the potential assets you want to invest in.
Also, decide the kind of money you want to put in.
Don’t go by what others are doing.
Dollar cost averaging offers flexibility in your investment plans.
Take advantage of this strategy and work towards improving the overall return scope.
Dollar Cost Averaging as a Useful Investment Strategy
Therefore, we can conclude that dollar cost averaging is a useful investment strategy.
While it can’t convert losses into profit for you, it can definitely put a cap on it.
However, as a user, you have to exercise proper judgment.
You must not lose focus on your investment target.
This will also help you decide the ideal asset allocation.
You can also choose the asset class based on the overall profit expectations.
As an investor, do not forget to undertake due diligence on your choice.
This alone can help you decide on a profitable proposition.
It is always better to choose a kind of investment that you understand well.
This will help you assess the progress in a more definitive manner.
Dollar cost averaging is primarily about managing returns without timing the market.
This is exactly why, even if your stock slides after one year of holding, your net position can be positive.
Even in the face of extreme volatility, this strategy helps you maintain profit.
So, in many ways, it helps you preserve the principal amount.
This strategy is best for long-term investors looking for low-risk opportunities.
If you want to earn a profit in a hurry, this is not the best approach.
Since you are buying small tranches, you have to wait for significant returns.
Perseverance too is very important to profit from dollar cost averaging.
You have to stay focused and save consistently.
Only then you can hope to garner returns in a constructive fashion.