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Investing in financial assets involves a lot of risks, including investment price fluctuation. The more the price moves against your investments, the more you lose. The more the price moves with your investments, the more you earn.
It’s tough for beginners to determine if the current price of the asset is high or low because of unfamiliarity with past price action. Therefore, it’s possible to enter the market at the worst possible moment - when the price is at its peak. In such cases, dollar-cost averaging could be an efficient way to handle price risk.
Definition: Dollar-Cost Averaging (DCA)
Dollar-cost averaging is one of the more conservative ways to invest in financial assets. It’s an investing method in which you put your money in with regularity and in equal amounts instead of as a lump sum.
Here's a simple example:
Imagine that you inherit $12,000 and you want to invest this money in a particular stock - Apple (AAPL). Since you’re a beginner, you don't know if the price of Apple is currently too high. If the price is at its peak and you invest all your money at once, it would likely be a pretty bad investment.
Dollar-cost averaging can ensure that you invest your money in equal monthly amounts. You can buy whatever amount of shares you can for $2,000 every month and you can do this for six months.
This way, you'll get a variety of spot prices which you can use to secure your investment. The bigger the variety of spot prices, the closer you get to the real value of the financial asset. You tackle the risk of buying a financial asset on an increased price.
- If AAPL costs $150 per share now, you’ll get 13 shares for the first month.
- If the price increases to $200 per share, you'll be able to get 10 more shares for the second month.
- If the price falls to $80 per share, you will be able to get 25 shares the third month.
- The price climbs back to $125 per share, so you get 16 more shares the fourth month.
- The price goes up to $181 per share, which buys you 11 shares in month five.
- If the price decreases to $100 per share, you can get 20 more AAPL shares in the sixth month.
Now, let's do the math.
- You spend: 6 x $2,000 = $12,000
- In total, you buy: 13 + 10 + 25 + 16 + 11 + 20 = 95 AAPL shares
- This gives you an average price per share of: $12,000 / 95 = $126.31If you would have spent all the $12,000 at the first month when the price was $150 per share, you would have gotten:$12,000 / $150 = 80 AAPL shares
Decide at what periods you would like to invest and what the amount will be. The only requirements are that the amounts are equal every time and the payment periods are evenly distributed. The lower the price goes over time, the more shares you will be able to buy even as you spend the same amount of money.
Pros and Cons of Dollar-Cost Averaging
Pros of Dollar Cost Averaging
- You lower your price risk. Since your investment is subject to price changes, it is less likely that you buy at an increased price. The bigger the time frame and the more often you buy, the closer you are to the real value price of the asset.
- You lower the damage. You can still invest in the wrong moment with the dollar-cost averaging method. However, the financial damage to your investment will be lower, because you invest over time during the price decrease. You do not buy with all the money at the highest price; you buy with only a small portion at the highest price. Then you continue buying on equal portions, but the price decreases.
- You isolate your emotions. You decide on the conditions you will follow. Emotions are not included. If you deviate from the conditions, you’re not dollar-cost averaging.
Cons of Dollar Cost Averaging
- You can forfeit higher gains. If a stock is at a low price and starts climbing, you will earn less than if you would have invested all the money as a lump sum.
- You are not 100% invested. The dollar-cost averaging method puts your money in cash for a longer period of time. Holding your money in cash is less risky, but at the same time, your money doesn’t earn anything.
- The odds are against you. An independent Vanguard survey determined that in 66% of the cases, it’s better to invest your money as a lump sum rather than via the dollar-cost averaging method. According to the survey, the higher the time frame, the more likely that a lump sum investment performs better.
- You’ll pay more broker fees. The dollar-cost averaging method consists of regular transactions and investments. Since the process involves more operational efforts, you may be subject to extra broker fees.
How to Use Dollar-Cost Averaging
Consider the dollar-cost averaging method only if you believe that the price is currently against you. If you don't have an idea about the price’s condition, then consider putting investing on hold.
Step 1: Decide on the Time Frame
If you want to invest in a particular financial asset, it is good to open its price chart and take a look. Observe the price swings and decide if the price is currently too high for you. If this is the case, then you might want to measure the size of the standard price swings. This might help you find out what time frame you would like to choose for dollar-cost averaging.
This is the Apple chart from November 2010 to February 2015. The chart shows a trend, a price correction, and another trend. The image shows a spot price position at $132 per share - the all-time high.
If you consider this price as high and you still want to invest in Apple, then you can consider the dollar-cost averaging method. See the correction between the two trends. It lasted for 10 months. Since Apple is a solid-trending company, we can expect some consistency from it. Thus, a 10-month time frame for your dollar-cost averaging might be suitable.
Step 2: Decide on the Number of Investments
The more payment periods you involve, the closer you will get to to a standardized price. At the same time, you need to distribute the periods in an adequate way. It is not adequate to make an investment every day. An adequate approach is to do the investments on a monthly, two-month or quarterly basis, depending on the fluctuation of the asset. Sometimes it can be appropriate to make the investments once a week.
A good way to decide the number of investments will be to check the inner price fluctuations in a period equal to the time frame you chose in Step 1.
Let’s get back to our Apple case. Say we have $50,000 for investing. A 10-month period will be well-distributed in 10 monthly investments of $5,000.
Let’s see how this will fit our Apple case from above:
Above, you see the continuation of the price action for the same chart. There are ten monthly price markers:
As you can see, you would have managed to purchase a total of 407 AAPL shares with the dollar-cost averaging strategy. If you have invested the $50,000 as a lump sum on February 2018, you would have gotten only 387 shares, or 5% fewer shares.
Step 3: Find a Good Broker
The best online broker for dollar-cost averaging will be subject to high financial regulation by the domestic authorities. This will give you a guarantee that the company is reputable.
Look for brokers with low transaction fees, as dollar-cost averaging involves many transactions. A suitable broker will also give you access to no transaction fee (NTF) funds, which at first sight sounds great. However, these might come with a higher expense ratio.
Some of the best investment firms for dollar-cost averaging are Ally Invest, E-Trade, and TD Ameritrade. These three brokers comply to the highest regulatory requirement. They give you access to a large number of tradable assets suitable for dollar-cost averaging investments. You will also find NTF funds there.
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Step 4: Strictly Implement Your Plan
The rules of the dollar-cost averaging investing are simple, but you will need to set these rules in advance and follow them strictly. If you want to attain the effect of the dollar-cost averaging method, you should not deviate from your approach. Invest your funds on time to reach full effect. This way, your investment will be safer, and if your plan is well-structured, you’ll experience the results.
Dollar-cost averaging is not the best investment approach. However, it can work in a positive way if implemented properly and in the right moment. You should consider dollar-cost averaging if you respond to these three conditions:
- You have a stock that you want to invest in.
- You decide that the price of the financial asset is relatively high.
- You want to invest now.
If you respond to these conditions, then dollar-cost averaging might be the right investment style for you. If you don’t like the sound of some of these conditions, then you might be able to find a better investment approach.
If you are not certain of the stock you want to invest, you can always change the financial asset and avoid the dollar-cost averaging method. If you believe the price is standard for the asset, you can simply invest your amount as a lump sum. In 66% of the cases, it offers better results anyway.