The Dollar Cost Average: For Beginners
By: Tanner Yarton
Hello Investors,
Today we are going to talk about Dollar Cost Averaging. Dollar Cost Averaging, or ‘DCAing’ is the practice in which an investor makes periodic purchases of a security (stock) to achieve a higher quality average price. Somehow that seemed like a lot to digest in so few sentences, so let me explain.
Lets assume that I am an average investor. I like Apple stock, ($AAPL) and I want to own it in my portfolio. Now, in this instance i’m a new investor. I don’t know much about Apple, investing or the market as a whole, all I know is that I like Apple and I want to own $10,000 worth of shares for 10 years (or until I believe it is worth selling).
Now, I have a couple options that I can take to own Apple, and they are as follows:
I can go out and buy $10,000 worth of Apple shares and forget about it
I can buy $1,000 worth of Apple shares every month for the next 10 months
In both instances, I will own $10,000 in Apple shares. What’s different between these options is the time in between the purchases. The first options seems the easiest. If I like Apple stock now, why not just buy it all at once? For starters, if im an average investor as I stated above, who is to say I bought at the right time? What if I bought at the peak of the market? Or any other market peak or near high? Retail investors are known to be poor indicators of market direction. If I did buy the right moment, great. More often than not, this is not the case and “time in the market > timing the market”.
The second Option, the DCA allows me to buy Apple at a number of different price points and times to give me a more well rounded price average. In addition to this, It removes the emotion of going all in at once, as well as forcing me to think longer term (longer buying period leads to longer holding period).
In a downtrending market like we’re in now, the DCA is a perfect choice. We don’t know where the bottom is, but we can use some statistical indicators from previous market downturns to help identify a potential range in which we may fall to in a certain amount of time.
Example:
Below is a calculator that lays out a DCA structure:
As shown, the investor has $1100 invested over 11 months. During every month, $100 is invested at whatever the market price of the stock is at the time. What this allowed is an investor to do is get a better price per share than if they had bought them all at once.
Below are the results:
With the DCA method, they achieved an average cost of $7.38 and a total gain (at the final period) of 35.6%. If they had taken the first choice, they would have gotten less shares, and been more exposed to the swings of the stock, which ranged all the way from $10 to $5. This type of emotion and volatility can shake out lots of investors, another reason why the DCA method is so strong for those who don’t have the appetite for the market like seasoned investors do.
Closing Notes:
In every example of the DCA, I see comments like “This only worked in this specific instance!”. You’re right. In my example, I showed that with a DCA method, the investor achieved a greater return than the lump sum strategy. But that is not to take away from the true lesson here, which is that as investors, we are poor at timing entries and holding through tough times.
Markets are inefficient, and often stop us out of positions just because the number on the screen is more red than we’d like it to be. Spreading out entries not only allows for better returns after downtrends, but also staves off some classic reasons why people stop investing as a whole. Buying a stock you think is awesome and watching it get crushed shortly after is a huge turn off. Setting systems grants us better sleep at night, as well as feeling productive in the portfolio over extended periods of time.
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Tanner