There are multiple ways to invest, with one of the more passive ways recommended by many is dollar cost averaging.
“Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset’s price and at regular intervals; in effect, this strategy removes much of the detailed work of attempting to time the market in order to make purchases of equities at the best prices.” – Investopedia
At the core of the fancy lingo used above, it means you put a fixed amount daily/monthly/yearly into a certain investment so that you average out your buy-in price.
Think of it like gardening where you need to tend to the plants regularly and conscientiously in hopes that it will grow well.
Dollar cost averaging illustration
For example, let’s say you’re buying into a Real Estate Investment Trust (REIT) counter on any market in Malaysia. Why? Because in most cases, it gives you steady dividends and that’s why it’s a good place to exercise dollar cost averaging.
Assume that you allocate RM500 per month to contribute to REIT 1. Every month you diligently buy up RM500 worth of shares in REIT 1.
I want to present two scenarios here.
If the prices go up monthly by 10 sen:
|Amount Invested||Cumulative Investment||Price||Investment Value||% Gain|
If the prices go down monthly by 10 sen:
|Amount Invested||Cumulative Investment||Price||Investment Value||% Loss|
Can you see the effect it has?
Pros and cons of dollar cost averaging
As you can see in the illustration above, with a 50% increase / decrease in the stock price by month six, the total returns / losses are reduced.
Yes, it’s a double edged sword. You minimise your potential losses and hopefully when it rebounds, you’ll get more returns. However, you also lose the full upside if the stock goes up in price.
The other potential risk here is that in most dollar cost averaging mechanisms, you set a fixed time in a month to invest that sum, such as the start or end of the month, when your salary is in etc. The issue here is that you could also be unlucky in that every time it’s time to invest, it’s at the higher price point for the month. That’s not fantastic but luck does play a part.
Then why do people recommend dollar cost averaging? If I were to guess, it’s because it gives people the “sense of calmness” that you don’t need to worry about the market’s ups and downs and just need to periodically invest a sum like clockwork.
I must add on that this was also popularised by mutual funds. At least, that’s where I heard this method being used the most, but I’m sceptical as they’re partially motivated by the sales charge.
Which brings me to… the case of commissions that we’re paying for any investments (depending on the amount). By doing a monthly dollar cost averaging investment, we’re technically paying 12 times a year at the highest commission rate (in most cases due to smaller investment size).
With that said, I do think there are uses for dollar cost averaging.
What I use dollar cost averaging on?
My journey on dollar cost averaging began with mutual funds. I’ve tried dollar cost averaging via direct debit on mutual funds a long time ago. The market was going up monthly and hence my cost was averaging up. Then one fine day the market decided to take a dip. That’s when I realised that the amount I’ve invested thus far actually suffered a much bigger loss due to my average cost being higher. Hence, I stopped doing dollar cost averaging.
Another asset that I’ve used dollar cost averaging on is bond funds via robo-advisors because their prices rarely fluctuate too much, but currently the only other investment asset that I practice dollar cost averaging on is gold.
Averaging down vs dollar cost averaging
What I prefer is to use the concept of “averaging down” in my investments.
I can’t control how the market moves and whether the prices will go up or down after I invest. What I can control is how and when I invest.
My approach is to always keep a basket of potential stocks in my watchlist. With this shortlist of stocks, I can then monitor where prices are heading. Rather than investing into a stock or any asset when the prices are up, I’d only invest when the prices fall to a target price.
When investing in a stock or asset, it’s possible that the price will fall below the invested prices. This is where averaging down shines as it takes on the benefit of dollar cost averaging to minimise losses and amplifies the profits via more investment in the particular asset. This is on the assumption that you’re investing in a fundamentally strong asset whereby prices will eventually turn around. However, it could take years in some cases, so patience is needed.
If prices are above my invested price, then I’d only think about when to realise that investment into profits. I’d seldom add on unless there is a particularly compelling reason to do so and would rather scour my watchlist for other stocks to invest in instead.
This approach is obviously not too relevant for short term traders but can be beneficial to the long term investors.
But how about non-stock related investments?
Modified dollar cost averaging
For assets such as robo-advisors, bond funds and gold, I do recommend the use of some form of dollar cost averaging. However, I’d keep the monthly amount small.
Upfront I will invest a lump sum amount and when prices fall substantially, I’ll average down again with a lump sum amount. Hence, I keep a close eye on the prices of these investments and have a ready cash pile to go in when prices are right.
This is my take on dollar cost averaging. I don’t use a straight up dollar cost averaging strategy as I believe with some active management, I can reap more benefits from my investments.
About the author
This article was originally published at betweenthemoney.com, a personal finance website by Jason Loh that focuses on money matters and investment topics for Malaysians