The Ultimate Guide To Dollar Cost Averaging
You might have come across the term ‘dollar cost averaging’ when reading investment guides or when listening to your friends talk about their forays into investment.
Dollar cost averaging (DCA) is a well-known and rather common investment technique that helps mitigate risks and is often employed for long-term investments.
What exactly is DCA?
In dollar cost averaging, you buy a fixed dollar amount of an investment on a fixed regular schedule regardless of the price of the shares. When you use DCA, you set aside, say, S$500 every month to purchase shares of Company X.
When the share prices go up, you purchase fewer shares with S$500, and when the share prices go down, you get more shares in that month.
Here’s a simple example to illustrate the concept.
|Month||Share Price of Company X||Number of Shares Bought|
|January||S$5||S$500/S$5 = 100 units|
|February||S$3.50||S$500/S$3.50 = 142.90 units|
|March||S$5.50||S$500/S$5.50 = 90.90 units|
If you had spent S$1,500 and invested it all in March, you would have only bought 273 shares and if you had invested it all in February, you would have bought 429 shares. In this case, with DCA, you had somehow balanced it out with an in-between.
This may sound counter-intuitive to the ‘buy low sell high’ mantra that you hear about investment, but it has its advantages.
Pros of DCA
DCA helps you avoid emotional investment decisions
Investing can be an emotional exercise if you are not careful, and it’s hard to keep the heart from racing when market news seems to swing from downright abysmal to overly optimistic. When share prices dip on negative forecasts, you may be swayed by anxiety to cut your losses short and on the other side of the coin, be tempted to put all your eggs in one basket when the economy seems to be roaring ahead.
With DCA, you instil some discipline into your investments while not losing out on the opportunity to accumulate more shares when prices are low. The stories of how billionaires caught the market at the right time (usually after a financial crisis) may be very tempting. However, thankfully, the economy doesn’t veer into extremes ever so often. The DCA technique is sensible in that it takes into account the reality that no one really knows when is the ‘best time’ to go in for the swoop.
You don’t need a stockpile of cash to be invested
Not everyone has a ready stockpile of cash for investments. For some, bonuses can be set aside for investments while for others, a modest salary allows for one to invest at a slow and steady rate.
With the DCA technique, you don’t necessarily have to accumulate the lump sum of cash before starting to invest, although that is the ideal situation if you want to take advantage of significant opportunities.
You have a low appetite for risk and a long-term investment horizon
You’re not in for the penny stocks that may become jackpots overnight, and neither are you keen on taking on the risk of investing a lump sum in a particular fund or share. Due to its risk-mitigating feature, dollar cost averaging is most useful when you want to invest in volatile instruments such as stocks and ETFs over a long period of time.
With DCA, you get rid of the need to find the perfect time to enter the market and your fixed dollar amount will enable you to accumulate more shares when prices are lower and fewer when prices are higher.
There may be lower returns than one who ‘catches’ the right timing, but there is less chance of ‘over-purchasing’ when prices are actually at their highest.
What to be mindful of with DCA
What dollar cost averaging should never be is an auto-pilot investment method that you simply forget about once it is set in place. Of course, taking the guesswork out of the picture saves us a lot of time and effort, but you still need to review your portfolio and determine whether or not that particular share is worth investing in, regardless of the method.
If the stock is fundamentally weak, for example, the company simply isn’t equipped to cope with technological changes and rivals, then you still need to make a decision about whether or not you want to continue investing in this company.
Also, remember that the dollar cost averaging method is not the only way to invest, though it certainly helps those who are new and not too confident about entering the market. By combining DCA with lump-sum investing, you would be able to maximise your returns while balancing risks.