Dollar-cost averaging [ DCA] :
Dollar-cost averaging [ In the UK it is called Pound-Cost averaging ] is a simple and uncomplicated investment strategy which doesn’t require you to read the charts or time the market to gain profits. This investment approach assists investors in lowering their risk of exposure to market uncertainty and increasing their wealth over time.
Here is the strategy and Logic behind it :
Instead of investing a large amount of money all at once, break your money into smaller parts and invest in a stock or fund at regular intervals for a period of time. If your goal is to create fortune with this strategy then you should invest in the same fund for a long period.
We all know that Market is quite unpredictable and handling volatility is not an easy task even for seasoned investors and traders. With this approach it is possible to skip all the guest work like “timing the market perfectly”, “analyzing the charts on multiple time frames”. Moreover, this strategy guarantees you peace of mind, even after investing in a market that is unpredictable.
Now lets move a step ahead and dive into more minute topics related to Dollar-Cost Averaging like pros and cons, how it is different and best from other investment strategies etc.
Example of Dollar Cost Averaging for Easy Understanding :
In this section we will explain about Dollar-cost averaging with an example.
Lets assume you are planning to invest in Alphabet [ GOOGL ] stock with the aim of generating decent returns from your investment.
Investment Amount : lets assume you have $5,000 to invest in a fund or stock [ In this case you have chosen GOOGL to invest].
As per Dollar-cost averaging instead of investing total $5,000 at a time, split the amount into smaller portions and buy accordingly over a period of time.
Instead of investing $5,000 at once you can go for $500 a month for 10 months or similarly you can opt for $1000 a month for 5 months.
Here we are going to stick with investing $1,000 on the first trading day of each month for the next 5 months.
As on January 4th, 2025 Google stock is trading at $191. For the purpose of easy calculation lets assume “Google stock” is trading at $ 100.
Google’s Stock Price Over the Past Five Months: [ Hypothetical Analysis]
GOOGL : $100 per share in January.
GOOGL : $80 per share December
GOOGL : $60 per share in November
GOOGL : $90 per share in October
GOOGL : $120 per share in September
Lets breakout the investment approach :
A $1,000 investment is made in the month of September at a price of $120 per share, resulting in the purchase of 8.33 shares.
October Month : At $90 per share, you will get 11.11 shares.
November Month : At $60 per share, you will get 16.67 shares.
December Month : At $80 per share, 12.5 shares.
January Month : At $100 per share , you will get 10 shares for your investment of $1000.
Total number of shares you hold at the end of 5 months : 11.11+16.67+12.5+8.33+ 10 = 58.61 Shares
Total Investment [ For 5 months ] : 5x$1000 = $ 5000
Investment value :
In the month of January stock is trading at $100 per share.
Total Stocks X CMP [ current market price ] : 58.61X 100 = 5861$
With an investment of 5000$ you have generated a profit of 861$ with in 5 months.
The fact that the final price of GOOGL in January was $100, which is more than the average price you paid ($85.34). In the first month the stock price was around $120, later it has seen a down trend and has seen a low of 60$. Even after the completion of 5 months, the stock price is below the first month’s buy price., but still you could generate decent returns on your investment.
The above example explains to you how dollar-cost averaging can work in your favor even when prices fluctuate.
Dollar-Cost Averaging vs Lump Sum Investing [ Front Loading ]
Dollar-Cost Averaging (DCA) and Lump Sum Investing are two key strategies you should look at while making investment decisions. Both approaches have their merits and downsides, depending on market conditions. One strategy works fine during the bull and another one works fine when the market is in downtrend or sideways.
It is recommended to choose a method based on the individual’s preference and circumstances of the market.
In simple terms :
Dollar-cost averaging is an approach where a person should invest in small portions at predetermined periods, without looking at the market conditions or stock price.
On the other hand “lump sum” investing is pouring all of your available funds at once in an instrument. [ it may be a stock or fund ].
During Bull Run :
If you implement Dollar-Cost Averaging strategy during a bull run then you are not using the full potential of the bull run to earn returns. Because during the bull run period you may have invested only a percentage of your available funds.
In the case of Bull run, Lump sum investing works like a charm as you are investing all of your available funds at once in a stock. This strategy gives maximum returns during a bull run.
During Volatile Market :
Implementing a “lump sum” investing strategy in a volatile market exposes you to immediate decline in the investment value. As you are dumping all of your funds at once and if the market goes against your direction then you have to face a loss on the whole amount invested.
Similarly if you go for “ Dollar-Cost Averaging strategy” in a volatile market, your investment amount is prone to less risk. As in this case you are not investing a total amount at a time.
When to Use Dollar-Cost Averaging Strategy ?
Splitting your investment amount into smaller portions and investing at regular intervals keeps you safe from uncertainty in the market. With this approach you are literally killing the danger of purchasing the stock with all the funds available at a time when the market is at its highest point.
This DCA approach perfectly suits investors who don’t want to take risks and who are not ready for an emotional rollercoaster ride. DCA can provide you the peace of mind in unexpected market conditions. You can also follow this strategy during a “Bull run”, the returns on the investment are going to be limited.
When to Choose Lump Sum Investing ?
If you are an avid risk taker then “Lump Sum Investing” is for you.
When the market outlook is favorable, investing in a lump sum can result in better returns when compared to any other strategy.
Another scenario where “Lump Sum Investing” can be useful is : When you have money in your pockets after selling property [or anything similar to that ], if you don’t invest it properly then the chances of misusing the fund is very high. In such cases you can go for a lump sum investment.
Conclusion : Hope we have given clear picture on what exactly is Dollar cost averaging and its pros and con’s when compared to strategies like lumpsum investing. In our upcoming blogposts we will cover more info on DCA like “Buying the dip vs dollar cost averaging”, “Dollar cost average in crypto especially bitcoin” and many more. Please do bookmark our blog and share it with your friends.
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