Dollar Cost Averaging Explained
‘Dollar Cost Averaging’ (or simply DCA) is one of the many strategies used by investors to build up their portfolio – be it stocks, bonds, mutual funds, or cryptos. The term ‘Dollar Cost Averaging’ was first used by Benjamin Graham in the book authored by him, The Intelligent Investor. Dollar Cost Averaging means that if an investor invests a particular sum of money in a particular asset class over a periodic basis (say monthly) rather than investing such sum altogether (on a lumpsum basis), then such an investor is likely to have achieved a lower cost per unit of investment. And hence achieve a relatively lower (and a much more satisfactory) average buy price.
It is to be noted that the amount of investment or the investment units are to be fixed. For instance, an Investor purchasing $10,000 worth of ETH every month can be considered to be following Dollar Cost Averaging or an Investor purchasing 5 ETH every month.
As a result, DCA can help one purchase more investment units when the asset price is lower and fewer units when the price is higher. Effectively, giving the investor a lower average for the units purchased over a period of time.
Certain investors also combine it with purchasing higher units (higher than the usual number of units) or investing higher amounts when the prices are relatively lower i.e. trying to time the markets.
However, recurring purchases also result in higher transaction costs (in the form of brokerage, commission, and bank charges) than a single, lumpsum investment.
Benefits
- Help in achieving a relatively lower purchase cost per unit of investment over time
- Removes the market timing risk.
- Suitable for Investors who do not want to make investment decisions daily
Other clear benefits also include the promotion of the habit of regular investing and the ability to easily automate the investing process.
DCA as an Investment Strategy in various markets
DCA is also dependent on market trends. Say, for instance, if a person invests $10,000 monthly for a year. The DCA will vary depending on whether it is a rising market, a fluctuating market, or a falling one.
- DCA in a volatile market
Even in a volatile market, Person A can maintain a satisfactory average of roughly $ 21.
Accordingly, Investor A can purchase 5661 units. The Current value of the Investment being $ 141,525, earning a return of roughly 18%
DCA in a rising market
In a rising market, Person A can maintain a satisfactory average of roughly $ 21
Over a year, Investor A has accumulated 5835 units. The current Value of the Investment is $ 145,875 earning a 21% return on the original investment of $ 120,000.
Dollar Cost Averaging and Lumpsum Investment
As previously discussed, the DCA strategy proves to be particularly useful to avoid a market timing risk, to which the lumpsum investment strategy is susceptible. A lumpsum investment made at a time when the markets are high can prove to be detrimental to the portfolio value of the investor.
Let us look at the example given below
Jacob invested $ 120,000 in a particular crypto token (at $ 20) and decided to hold it for a year. Accordingly, he bought a total of 6,000 units.
Whereas Alex decided to invest $ 120,000 in the same token but using the DCA strategy.
The price movement of the token during the year was as follows.
Accordingly, Alex bought 6,416 units over a year. With the amount invested being $120,000, the average cost of the portfolio is USD 19 per unit.
After a year,
Jacob has 6,000 units worth $240,000, earning a return of 100% on his investment
However, Alex has managed to buy 6,416 units worth $ 256,640, earning a return of roughly 114% on her cost of $ 120,000.
Overall, both parties may have earned impressive returns but Alex has been able to achieve a relatively higher return because of the significant drop in the price during the fourth month, which enabled her to purchase 1,000 units at a relatively lower price
Other concerns for DCA
However useful it may seem, the DCA is not an infallible method of investing that guarantees better returns. In a constantly rising market, the benefit of the “Buy more at low” simply does not exist. An investor following DCA might just buy at a higher price and be worse off than an investor who has bought lumpsum units.
Also, the DCA is not a substitute for a poor investment decision or a constantly poor-performing market. DCAing a stock or cryptocurrency with poor fundamentals or technicals might be of no use if one is not able to sell it at a high.
All said Dollar Cost Averaging is an excellent tool to inculcate the disciple of investing fixed sums.
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