How to Invest with Dollar-Cost Averaging?
When the market is volatile, it becomes very important to know the right time to capitalize on an investment. If you have been investing in different assets to generate wealth, you must have come across different approaches and strategies to improve your investment position. Remember, there is no clear winner when it comes to investing and everything has its own place in a particular setup. To some ‘buying only the dips’ offers an advantage, while to others ‘value averaging’ remains a preferred option. But a common strategy that has been a dependable option for many decades now is dollar cost averaging or DCA. Knowingly or unknowingly, many people make their investment through this method to reduce market risk. Here’s what you need to know.
What is Dollar Cost Averaging (DCA)?
Known as constant dollar plan in the U.S., and pound-cost-averaging in the UK, DCA is an investment strategy in which the investor divides the sum in equal amounts and then invests it into the market at regular intervals. In essence, the investment is made at regular periods regardless of the asset price, so investors don’t have to take on the most daunting task of timing the market. This, in turn, helps the investor buy more shares when the market is dipping and lesser shares when they are running high. The strategy benefits investors by lowering the average unit cost, especially if the investment is spread over a longer period of time.
Here’s the math:
Let us assume an investor has to invest $1000 for each of the first five months of a year, in a particular mutual fund. With fluctuation in the prices, the number of shares he would buy each of those months would also vary.
|No. of shares bought by investing $1000
|Price of each unit
After five months, the investor can acquire a total of 298.14 shares and the investment of $5000 can increase to $6857.11. The average price incurred is $16.77 as against the current average of $22.09.
Steps to be followed:
If you are investing through DCA, you must broadly chalk out 3 things. Firstly, decide on your investment capability that you can maintain over the course of the term. Secondly, have a sound knowledge of the portfolio option in which you are going to invest, as you may want to hold the asset for a longer period of time (typically more than five years). Lastly, decide on the duration of the spread. It can be weekly, monthly, or quarterly, as long as it is fixed at regular intervals.
Pros of investing through Dollar Cost Averaging:
1. It makes the investment more affordable
One of the major advantages of DCA is that it evenly spreads out the investment. It is easier to pay in monthly or quarterly installments rather than investing the lump sum amount at once. DCA is a lot similar to paying a credit card bill. Since not many people can afford to invest huge sums of money at one go, DCA brings investment to the masses and debunks the notion that investing is only for the rich.
2. You get the average price
Since the market is volatile and fluctuations are undeniable, DCA lets you purchase the asset at an average price per unit over a period of time. This smoothening effect helps dodge market volatility, especially if the investment is spread for a longer-term. You can get a clearer view of the market by investing through DCA. This also helps in making smart financial decisions in the future.
3. Takes emotion out of the equation
Since you invest at regular intervals regardless of the asset price, you tend to keep impulsiveness at bay. Much of the guesswork in timing the market nervously is reduced to a bare minimum. It not only saves you from bailing out your investment when the asset prices are falling but also helps you buy a greater number of shares for the same amount.
Cons of investing through Dollar Cost Averaging:
1. Cash drag
These are funds that an investor holds for a certain period of time that do not yield any return. Since the investment through DCA involves investment through a very protracted period of time, the investor holds a lot of money which is not in the market.
2. Missing on the up-trending returns
Usually, after a financial crisis, it is rather easy to predict an upward rising market. But if you are averaging your investment through DCA, you might end up losing some extra bucks.
3. Higher transaction fees
Since DCA involves more transaction you may end up paying more brokerage fees, especially if you are investing in assets such as stocks or mutual funds. However, this may not always hold true for all investments. For example, investing for your retirement through a 401(k) plan will not come with hidden transaction fees. In fact, if you are enrolled in the 401(k) retirement account, you may already be taking advantage of the DCA.
4. Reduced risk theory is debatable
According to financial experts, DCA just delays the market risk rather than reducing it, so investors should focus more on their asset allocation rather than investing in installments.
Alternatives to DCA:
If DCA does not seem like a good fit to your financial plans, you consider these alternatives:
1. Value averaging
This can be a form of up-gradation to DCA, where an investor invests more when the asset prices are falling and less when they are on the rise. This works in contrast to DCA where you have to invest the same amount periodically.
2. Buying dips
Investing in a stock or a fund only when the prices fall can also provide better returns. But this method demands an active participation from the investor and only works well if the investor is following the market closely.
3. Lump-sum investment
This alternative may not suit everyone, but investing a lump sum amount at one go is not a bad idea, especially if one can time the market well.
To sum it up
Overall Dollar Cost Averaging is a viable technique especially for those who cannot afford to block all their money at once in hope for future returns. But it is not a magical potion for yielding guaranteed returns, and may land you on the losing front if you pick the wrong investment.
A highly overlooked advantage of DCA is that it brings discipline into your investment regime. It also serves as a great medium to save for the future and offers a preset investment option for people who do not like being exposed to market swings. But being able to identify good investment avenues is very important.
If DCA sounds like the ideal strategy for your financial goals, consult financial advisors and find out how you can adopt this method to maximum your returns.