CFO of Life #48: Dollar Cost Averaging: A Beginner-Friendly Investment Strategy

Every investor can simply Dollar Cost Average into the market of their choice and forget about any fancy active investing strategies, and here’s WHY!

If you take $1,000 and immediately buy a stock, you will buy it at whatever the current market price is. On the contrary, if you take the time and continuously buy over time, you will get some shares at a lower price and some at a higher price. This would result in you paying various different prices for the same stock, but over time, it would help you smooth out the average purchase price and cancel out a lot of the market volatility.

Plus it will keep you accountable and make you stick to your investment habits. This by itself is a big plus, as most of us could easily fall prey to FOMO and try to chase market returns, which is not healthy in the long run and more often than not, it results in substantial losses. That’s why, today I’d love to introduce to you the concept of Dollar Cost Averaging (DCA).

But What is Dollar Cost Averaging (DCA)?

Dollar-cost averaging (DCA) is an investment strategy/approach which prescribes that the investor would invest equal amounts of money, at regular intervals of time, in the same assets regardless of what the price is. This aims to shield the investor from the volatility of the market and simplify the decision-making process for the investor.

Here Are a Few of the Benefits of DCA:

? It can reduce volatility's impact on your investments

? It will keep you accountable and help you invest on a regular basis

? It is a simple no-frills approach to investing that would minimize the impact of your emotions

? It is an extremely beginner-friendly strategy

? It is a great strategy for any type of investor

? It is an easy strategy to follow for long-term investing

Overall, it is a really sound investment strategy that anyone can use and benefit from lower risk and volatility. Plus, any beginner investor can use it to build their investment habits and stick to their investments through thick and thin.

But How Does the Math Behind DCA Work?

Gladly I can say that the math of DCA is super simple, but you need to pay attention for a moment.

Here is an example of how DCA works:

You decide to invest $100 per month into a particular stock.

In month 1 the stock price starts at $10 per share.

You buy 10 shares.

In month 2 the stock price then goes up to $15 per share.

You buy 6.67 shares.

In month 3 the stock price then goes down to $5 per share.

You buy 20 shares.

Over time, your average purchase price will be $10 per share. And at the end of month 3, you will have 10+6.67+20 = 36.67 shares in total.

Whereas if you purchased all of the stocks in month 1, you would have had only 30 of them. But using the DCA approach, you build up on this with 6.67 shares that you wouldn't have had otherwise. And that’s the power of Dollar Cost Averaging.

What’s the Power of Dollar Cost Averaging?

It is a simple step-by-step approach:

1. First you choose what assets you want to invest in

2. Then you choose how much you want to invest, be it a % of your salary or a fixed amount

3. After that, you choose how frequently you want to invest ie. daily, weekly, monthly or whatever interval works for you

4. When you are ready, you choose when to invest ie. at a fixed date - 1st of the month, last Friday of the month or whatever best fits your schedule

5. From time to time, you should review and adjust your investing plan according to any changes of your goals or your circumstances

If you follow those steps, you will be well on the way to setting up your Dollar Cost Averaging strategy. And over time, it will smooth out the average price for your investments and dampen the effects of volatility.

At the same time, the amount you invest would also influence the equation, as if there is one occasion when you buy more at a higher or lower price, you would then skew the average price. That’s why it is good to buy regularly with the same amounts, to prevent skewing your price.

Last but not least, the time horizon of your investment would also play a big part in this puzzle. The longer you are in the market, the more likely you are to capture a variety of prices.

But Who is DCA for?

Dollar-cost averaging (DCA) is a simple and easy investment strategy that is suitable for any type of investor.

It’s especially suitable for people who are new to investing as it helps you reduce the ambiguity of “What should I do?”, “When should I invest?” and “How much should I invest” - as the greatest hurdles for new investors. It also teaches you how to think about your investments and how to slowly grow them.?

It is also good for investors who don’t have a huge income, as you choose how much you want to invest and how frequently. It will allow you the ultimate levels of flexibility and reduce the guilt if you have to miss a few dates as life gets in the way.

It is also great for people who need to learn how to control their emotions around investing. This is normal for a lot of new investors, as they have never experienced a market downturn and the drawbacks that can come with it. That’s why DCA is good, as it helps you smooth out your investments over the long term and brings benefits from those market downturns.

DCA is also good for people who are not comfortable with risk. By investing smaller sums of money on a regular basis, you are spreading out your risk and you are less likely to lose a lot of money if the market takes a downturn.

DCA is one of the best methods to invest in the long term. Because it literally helps you set up everything, contribute regularly, and all you have to do is a routine review every 6-12 months to ensure you are still on track with your goals and adjust any investments that need it.

With all that positivity, I can definitely hear you saying ”But DCA can’t be a silver bullet for all my investment needs! Are there no problems with it?” And you will be correct, as with everything else, DCA has its own shortcomings.

What Are the Shortcomings of DCA?

Here is a list of important drawbacks of DCA that you should be mindful of:

You might miss some of the market gains as the market might move at the odd moment when you are not in your investment window.?

You might pay more for some assets in the long run, if their price keeps growing, compared to the same situation if you buy less frequently but bigger lump sums of money.

You might incur additional transaction fees, as some investment assets have higher fees associated with them, and if you invest small sums of money on a regular basis (daily/weekly) those fees will add up.

It can take longer to reach your goals as if you trickle down a big lump sum of money, it will take time to see returns, compared to investing a big sum of money at the same time.

Last but not least, if the market takes a wild downturn (February - March 2020), then you might panic and sell your investments to lock in any remaining profits or minimize your losses. And that is normal human behaviour that no strategy can account for.

Now, DCA is not all negativity and you can easily adapt it to your needs, but you need to be mindful of the shortcomings and safely execute it to achieve your goals

Here Are Some Tips for Safely Using DCA:

Ensure that you invest enough to steadily grow your portfolio, but not to hinder your day-to-day life. It is essential to choose an amount that you want to invest and you can easily keep up with. And the easiest thing to do is to take a fixed dollar amount or a % of your salary and invest it on the day that you get paid.

Invest for the long term as Dollar Cost Averaging works best in the long term and don’t expect to see huge profits overnight. But with time, you will see the profits rolling in and outweighing the risks.

Make sure that you have a well-diversified portfolio if you have all your eggs in one basket, it would be easy to break them! Spread your money in different assets or at least in more than one sector of the economy to protect yourself from the higher-than-normal downturn.

Make sure you rebalance your portfolio on a regular basis. As your investments grow, you should take the time and ensure you are keeping with your financial goals and your risk tolerance. This might mean collecting profits from the investments that have done well and reevaluating those that performed poorly.

If you think that you like the idea but you don’t know enough about the world of finance, it’s always good to get professional advice. A financial advisor can easily help you set up a plan for your DCA that works for you and your needs.

As with everything, it is extremely important to understand what are the pros and cons of Dollar Cost Averaging before you start using it. If you feel comfortable sticking to your plan, DCA can be a great investment strategy. However, if you think that it involves unnecessary risks or you are not sure about sticking to your plan, then you may want to get professional advice or use a completely different investment strategy.

Regardless of what investment strategy you want to use, next week we will focus on how to automate your investments and when it is actually a good idea to do so!

Thank you for reading! All comments and topic suggestions are highly appreciated. Post #48 in the series CFO of Life

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