June 30, 2020 |James Messi
What is dollar-cost averaging?
Dollar-cost averaging (DCA) is an investment strategy. The principle purpose for dollar-cost averaging is to reduce exposure to volatility and its impact on your purchase. Anyone can do it, it’s not a particularly complex investment strategy and can be done to differing levels of ease with almost any financial platform.
The key process of Dollar-cost averaging involves putting a set amount of money into buying an asset on a regular basis in order to avoid issues that may arise from buying vast amounts of the same asset within a short period of time. Although anyone can dollar cost average, the ideal candidate would be someone who is saving for a pension and wants to get exposure to an asset or market and slowly build a position.
The benefit of regular reinvestment
Dollar-cost averaging is used by many investors to reduce their risk of temporary fluctuations. In order to successfully ‘buy the dip’ of the market, normally a trader has to undertake a significant amount of research, as well as being very lucky. By Dollar-cost averaging you’re taking the need to do excessive analysis out of the equation. You’ve reduced risk by avoiding chances of accidentally buying at the wrong time whilst also maintaining similar profit levels
In bear markets, it can be a good way to lower your average cost and increase your percentage share of the market or stock in question.
Many investors can be put off from investing because of a lack of significant starting capital and from not seeing significant returns. A $50,000 return from a $1,000,000 investment is the same (in percentage terms) as a $50 return from a $1,000 investment. One is more encouraging than the other and so new investors can be put off from long term investing by small returns at first. Dollar-cost averaging is an effective way to invest for low-level investors because for many it feels more like a routine than a conscious financial decision.
Finally, it can be a highly effective trading strategy for those who don’t have a large pool of funds to invest like inheritance or savings. Instead, it can be a way for someone working a regular job to gain exposure to the stock market.
What are the drawbacks to recurring purchases?
Although Dollar-cost averaging can be a sensible and useful tool, in certain circumstances, it would be better to buy large amounts quickly as opposed to spreading your investments across time periods. Here are some of the drawbacks from DCA:
The first point to make in terms of drawbacks is that markets tend to trend upwards. Of course, some projects and companies will slow down or fail, and even during short term windows, all markets can go down, but using historical data it’s clear that the overwhelming majority of traditional markets trend upwards. Examples include the S&P 500, FTSE 100, Dow Jones, and most major stocks themselves. By buying small amounts of the stock over a period of time you may inadvertently be decreasing your returns in comparison to someone who bought larger amounts over a shorter period of time.
As will be described later in the article, if you’re not careful to look into fee structures you may be better off buying lump sums rather than small amounts. For example, if you use a platform that offers fixed fees and is tailored towards big customer then you may be incurring a small nominal fee but a large percentage fee. In the short term, this might be unnoticed but in the long term, if you reinvest dividends, those fees could seriously eat into your returns.
Best Practices for dollar-cost averaging
1) Pay attention to fees
As described in the last paragraph, fees are key. If you don’t properly address the issue of fees and their impact on your portfolio, you may be severely stunting your returns. The two main areas to look at are deposit fees and market fees. Most platforms don’t charge deposit fees because it can disincentivize customers from making deposits but some do and thus if you’re making regular deposits in order to buy small amounts, you’re decreasing any potential gains. In addition, if fees are fixed rather than variable, that can hurt your returns as well.
2) Use DCA until you’re ready to make a bigger investment
If you like the idea of investing in a specific company’s stock and think their vision is good but getting a full understanding of various aspects of the project will require more time. If you don’t want to miss the opportunity to buy into it the company then you might decide to start dollar-cost averaging into the stock whilst you start supplementing your knowledge. The benefit of which being that you aren’t too heavily invested to back out if you’re dissatisfied with the knowledge you acquire. On the other hand, if you’re happy with your findings in the research, you’ve already invested and started your journey.
3) Ease of entering the market
Some platforms offer features specifically designed for those looking to DCA. Looking for these platforms can be extremely beneficial. The process of entering funds into a platform on a regular basis can cause a severe opportunity cost to the investor. Why spend your time moving money around when you could be doing other productive things?