Moreover, if you
purchase a stock based on your feeling that the market will go up, that will be
considered as speculating and not investing. So what’s the solution for
new investors who want to start investing in the stock market? There is a
simple solution for beginners who want to limit their risk while investing in
the stock market. What I want
to introduce to you readers is an investment strategy called Dollar Cost
Averaging. Dollar-cost averaging is a popular strategy for building investment
positions over time. This investing strategy is simple and can be effective for
new beginners who want to start investing in the stock market. In addition, I
will also explain the pros and cons of this investing strategy.
Let’s
Take a Look At This Chart.
Before I start explaining what dollar-cost averaging
is. I want to show you a chart below of three different stock prices
performance. If you had $1,200 to invest, which investment would you buy?
For most people, the answer is obvious. Investment A is the most
consistent and also has increased the most. If you had invested $12,000 in Investment A,
your investment has gone from $12,000 to $24,000.
Investment B would have grown to $18,000, and Investment C would have recovered to the
original $12,000 investment.
But what if you invested $1000 per
month instead of the lump sum of $12,000 all at once right at the beginning of the
month? Believe it, or not Investment C would actually be the winner in this case
scenario, giving you a portfolio value of $17412.70 while Investment A and B would
both end up at about $15,950. When investing regularly, dollar-cost averaging
can work in your favor.
What
Is Dollar-Cost Averaging?
Dollar-cost averaging is investing an equal dollar
amount in the market at regular intervals of time. This can be the beginning of
each month, where you invest the same amount whether the stock market is going
up or down. The idea is to get the best deal on the desired investment by controlling
for market fluctuations. Rather than trying to time the market, you buy in at a
range of different price points. By using this investing strategy, you are
building investment positions by fixed dollar amount at equal time intervals,
as opposed to simply investing a lump sum of your money at one time.
Let’s say; I want to invest $12,000 into
a particular stock; however, I have no idea whether the stock price will go up
or down in value in the short term. Instead of investing all the money at once,
I invest $1000 on the first trading day of the month for the
next twelve months. When prices drop, investors often get concerned because the
value of their portfolio drops. However, with dollar-cost averaging, investors
systematically take advantage of price drops by buying more units of the same
investment. As you can see, the example I place below, as the price drops in
the first seven
months, more and more
shares are being bought every month.
Month
|
Dollar Amount Invested
|
Price Per Share
|
Units Bought
|
Cumulative Units
|
1.
|
$1000
|
$10.00
|
100
|
100
|
2.
|
$1000
|
$9.00
|
111.11
|
211.11
|
3.
|
$1000
|
$8.00
|
125
|
336.11
|
4.
|
$1000
|
$7.00
|
142.8571
|
478.9671
|
5.
|
$1000
|
$6.00
|
166.6666
|
645.6337
|
6.
|
$1000
|
$5.00
|
200
|
845.6337
|
7.
|
$1000
|
$4.00
|
250
|
1095.6337
|
8.
|
$1000
|
$6.00
|
166.6666
|
1262.3003
|
9.
|
$1000
|
$7.00
|
142.8571
|
1405.1574
|
10.
|
$1000
|
$8.00
|
125
|
1530.1574
|
11.
|
$1000
|
$9.00
|
111.11
|
1641.2674
|
12.
|
$1000
|
$10.00
|
100
|
1741.2674
|
By investing a portion of my initial capital into several time
periods, I slowly build up my stock position. Alternatively, dollar-cost
averaging can be used to build a stock position in a volatile market quickly.
The power of the dollar cost average happens when the price rebounds and comes
back because you now own more shares of that particular stock. You can see this
in the 12th month when the price comes back to the starting price of $10; the
portfolio has grown to $17,410 from a $10,000 of
the total contribution.
Month
|
Dollar Amount Invested
|
Price Per Share
|
Units Bought
|
Cumulative Units
|
Cumulative Value
|
Amount Invested
|
1
|
$1000
|
$10.00
|
100
|
100
|
$1000
|
1000
|
2
|
$1000
|
$9.00
|
111.11
|
211.11
|
$1900
|
2000
|
3
|
$1000
|
$8.00
|
125
|
336.11
|
$2688.90
|
3000
|
4
|
$1000
|
$7.00
|
142.8571
|
478.9671
|
$3352.80
|
4000
|
5
|
$1000
|
$6.00
|
166.6666
|
645.6337
|
$3873.80
|
5000
|
6
|
$1000
|
$5.00
|
200
|
845.6337
|
$4228.20
|
6000
|
7
|
$1000
|
$4.00
|
250
|
1095.6337
|
$4382.50
|
7000
|
8
|
$1000
|
$6.00
|
166.6666
|
1262.3003
|
$7573.80
|
8000
|
9
|
$1000
|
$7.00
|
142.8571
|
1405.1574
|
$9836.10
|
9000
|
10
|
$1000
|
$8.00
|
125
|
1530.1574
|
$12,241.30
|
10,000
|
11
|
$1000
|
$9.00
|
111.11
|
1641.2674
|
$14,771.40
|
11,000
|
12
|
$1000
|
$10.00
|
100
|
1741.2674
|
$17,412.70
|
12,000
|
Dollar-cost averaging is an investment strategy that helps
investors fight the fluctuation in the market and potentially profit from
systematically buying low when prices drop.
The strategy can also be used to accumulate stock positions over
a period of years. For instance, I know a person who is not an expert in stock
picking. However, he found a solution of investing in the S&P500 index fund
(Ticker: SPY) using a dollar-cost averaging strategy. All he did was to keep
investing the same amount at the beginning of each year. He has done this for about
a decade and has no plans to stop or modify the strategy.
By applying dollar cost averaging in a stock investing, you
reduce the risk of unpredictable market crash that can happen in the near term.
By investing the same amount every month or year, you automatically buy more
shares when the market is down and fewer shares when the market goes up.
Dollar-cost averaging is an excellent investing strategy for
beginners who want to start investing. Beginners might receive a large bonus
from their work or inheritance from their parents or simply wanting to move
money from a savings account to an investment account. Rather than investing
all your money at once, you can invest a portion of the same amount in an
interval period of time.
The Benefits of Dollar-Cost Averaging
There are many benefits of using dollar-cost
averaging as your stock investing strategy. If you are still a beginner in
investing, then dollar-cost averaging can be a good strategy for you to apply.
It Reduces Risk
Dollar-cost averaging reduces your investment risk. By keeping
some of your money out of the market for some period of time, your overall
investment strategy is more conservative and less susceptible to a market
crash. If you invest your money all at once in a particular investment, there
is a risk that you will invest before big market turmoil. Imagine what would
happen if you invested all your money in the year 2007 just
before the recession that happened in the year 2008.
You would have ended up losing more money than if you had invested only some of
your money before the downturn.
You Buy Low
Some argue that applying the dollar-cost averaging method can actually increase
your return. Since if the stock goes down in value, the same amount of money
you invest regularly would automatically purchase more shares. However, you
would end buying lesser shares if the stock goes up in value. Dollar-cost
averaging causes you to add more shares into your portfolio when the market is
down, and it can lead to better returns in a declining market. After all, as a value
investor you
want to buy stocks when the market is in a bear territory.
Let’s take the
period during the financial crisis as an example. The chart I placed below
shows what if you had invested $1,200 from 1 January 2008 into MSCI World Total
Return Index (include dividends) using the lump sum method (orange-colored
line). Twelve months later, your investment would be worth $716 —
an Annual loss of 40%.
However, if you had to use a dollar-cost average method (blue
colored line) by investing $100 each month for 12 period
times, your investment would still have fallen but not as much as if you put a
lump sum. By 1 January 2009, your dollar-cost averaging investment method would
result in you to have $867. An annual loss of 28%.
The
Downsides of Dollar-Cost Averaging
Yes, there are indeed many benefits of applying
dollar-cost averaging as your investment method; however, there are also a few
downsides.
Lower Expected Return
Every investment decision involves a trade-off
between risk and return. If you want the opportunity to earn a higher return,
then you have to accept a larger risk. This is the same with dollar-cost
averaging. Although it can lead to better returns in some cases, however, most
of the time, the lower risk comes with a lower return.
The reason for this is simply that the stock market goes up more
often than it goes down. So by investing all your money in little bits over
time instead of investing it all at once, your odds of missing out on earning
higher returns are more significant than your odds of avoiding losses.
According to a 2012 Vanguard
study, investing all
your money at once would historically have produced a higher return than
applying dollar-cost averaging about 66% of
the time. This means that if you invest a lump sum earlier, it is likely to
have a better result than smaller amounts invested over a period of time.
Dollar-cost averaging will typically lead to lower returns in exchange for
lesser risk.
Let’s take another illustration with the chart I placed below.
Let’s compare if you had invested a lump sum amount of $37,200 (orange-colored
line) and we compare it with the dollar cost average method of having $100 monthly
investment (blue colored line) for 31 years to
make it equivalent to $37,200 (31 years x $100/month) in the MSCI World
Total Return Index from 1 January 1988 all the way to 1 January 2019.
The lump sum (orange-colored line) investment would result way
better if we expand the time horizon to 31 years.
According to our calculations, the lump sum method (orange-colored line) would
be worth $350,000 or an annual return of 7.5% by
the year 2019. However, the same amount invested incrementally
over the same 31 years would only be worth $123,395,
or an annual return of 3.9%. This shows that the lump sum method beat the
dollar cost average method in the long run.
Not a Substitute For
Finding Good Investments
Dollar-cost averaging is not a magic formula for
investing. It would help if you still did your due diligence in finding a stock
that has a strong business model and fundamentals. If the investment you pick
turns out to be a bad pick, you will end up investing steadily into a losing
investment. There’s no point in investing in a stock that will eventually go
out of business. You could end up losing all the money you have invested in the
company.
I personally suggest using a dollar-cost averaging investment
method on low-cost index funds such as the S&P 500 Index Fund (Ticker:
SPY). The S&P 500 Index Fund allows investors to establish a core
allocation in large-cap U.S. equities. Warren
Buffet himself has
advice people who have little understanding in stock investing to invest in the
S&P 500 Index Fund. According to historical records, the average annual
return since its inception in 1926 through 2018 is
approximately close to 10%. So if you have trouble trying to figure out what
stock to invest in, I would suggest using the dollar-cost averaging strategy on
index funds such as the S&P 500 Index Fund (Ticker: SPY).
Is
Dollar-Cost Averaging Right For You?
After describing the investment strategy of
dollar-cost averaging, I hope you readers now understand the benefits as well
as the downside to this investment strategy. I really suggest people use this
strategy if they are worried about losing all their money at once. If
dollar-cost averaging helps you to invest with less anxiety, then go for it.
But bear in mind, applying this strategy doesn’t guarantee that you will limit
your loss. Investing in a company that is terrible fundamentally and have a
poor business model could result in you to lose all your money invested.
From a purely analytical standpoint, it’s typically more
efficient to invest your money all at once into appropriate asset allocation.
This is because, in the long run, the stock market goes up more than it goes
down.
Conclusion
I hope from this article, you readers have a better
understanding of the dollar-cost averaging investing method. Applying this
strategy has its pros and cons. Dollar-cost averaging is an investment strategy
that helps investors fight the emotion of a downturn in the market and potentially
profit from systematically buying low when prices drop. If you are a less
experienced investor and dislike the fluctuation of the stock market, then the
dollar-cost averaging method may be suitable for you. On the other hand, if you
are an experienced investor, you might consider investing using a lump sum
approach rather than going for dollar-cost averaging. Hopefully, after reading
this article, you readers can decide which investing method is suitable for
you.
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