What is dollar cost averaging?
Most people accept that timing market tops and market bottoms is a near impossibility. The question then is how you put money to work in a market in an efficient manner.
Proponents of dollar cost averaging say that the best way is simply to drip feed money in on a regular basis. Take a basic example. Your monthly investment allowance is $100. Under DCA you’d invest the amounts as in the table below.
In this example, the investor has dollar cost averaged over 8 months and grown a position size of 16.5 units. The average price in the purchases was $50.90.
|Price||DCA amount||Position||Position Value||Profit|
If the investor had put the whole amount in at month 1, the price achieved would have been $35 and the investor would have bought 23 shares. The profit, ignoring fees and costs would have been
(55.31 – 35.00 ) x 23 = $467
That’s over 4 times the $114 profit under dollar cost averaging.
Take a second example.
|Price||DCA amount||Position||Position Value||Profit|
Here the market price dropped from $35 to $23.14. The investor dollar cost averaged in at an average price of $26.09. As the price has fallen, the investor has lost money over this period. The loss stands at $72.13.
Had the investor put in a lump sum of $800 on the first day, the loss would have been.
(23.14 – 35.00 ) x 23 = -$272
Obviously that’s much worse than the $72 loss that would have happened under DCA.
What this confirms is dollar cost averaging smooths out extreme returns. The investor didn’t suffer the steep losses, because of the falling price, in the second example. Neither did the investor capture as much of the gains in the first example where the price was rising.
When DCA is most beneficial
Dollar cost averaging is most advantageous when prices are volatile, but rising over the long to medium time. DCA investing is suitable for those looking to make gains over that time range. It isn’t appropriate for short term speculation.
Take a money market fund as an example of an asset that has extremely low volatility. The return profile of most money market funds is practically a straight line, because the price rises steadily as interest accumulates.
There wouldn’t be any advantage to dollar cost averaging into such an asset. In fact, if the investor had the cash available from the outset it would be unfavourable because that cash would not have been invested and earning interest from day one.
At the other extreme is a volatile growth stock or a cryptocurrency asset. These kinds of assets may experience long periods of bull phases where prices are rising very fast. At other times they will experience deep and sharp corrections that will rattle out all but the most stubborn investors.
Taking a large single position in this asset will be risky. Over the short to medium term the price could fluctuate wildly. If an investor is unlucky and hits an extreme market high, they might be waiting a few years before their account gets back in the black.
With dollar cost averaging, purchases are spread over a long period so that the investor benefits from a price average.
The downside, as the examples above show, is that the investor would not benefit as much from price rises had they been lucky with market timing.
This downside is lessened with time as the position size gets bigger.
Discretionary dollar cost averaging
One of DCA’s big selling points is that it is entirely passive. In theory, an investor does not have to think about price movements, timing the market, bubbles, crashes and the like.
Once committed to the plan, the investor just makes regular payments. This is why this “set and forget” method is widely advocated by mutual fund providers.
Proponents of it say that thinking is actually disadvantageous because it can lead to unconsciously trying to market time.
Obviously this doesn’t suite everyone’s needs. Discretionary dollar cost averaging is where the investor still drip feeds regular payments but uses some of their own judgement.
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This approach is much more appealing to hands-on investors, because it gives them some degree of control.
One technique is increasing the amount invested on dips and decreasing it on rallies.
As an example, when the current price is below the average entry price over the last 10 payments, the cash allotment is increased by 10%. When it is above the average it is reduced by 10%.
This is still a mechanical investment technique but it appeals to those who want a passive system. This works much like a grid trading strategy.
In a more active system, the investor enters in stages. Here though they actively try to time the most opportune entry prices over a certain period.
Averaging out of a position
If you believe the premise of dollar cost averaging, then averaging out of a position is just as important as averaging in, if not more so. This rule is often neglected by those without an exit strategy
Some investors follow the system for years only to panic in a market crash and sell everything in one go.
On the other hand, some investors watch the price get to extreme highs, only to remain invested as the market crashes and their profits evaporate.
Averaging out of a position just means taking profits in stages as your target are reached. This is nothing less than dollar cost averaging in reverse.