Dividend Growth Bunny: Dollar Cost Averaging Investment Strategy

Tuesday, December 10, 2019

Dollar Cost Averaging Investment Strategy

Many investors who are new to stock investing tend to worry about when to enter the market. It’s normal for new investors to feel this way since they don’t want to risk losing their hard-earned money. When I was new to the stock market, I got afraid when the stock went down in value and ended me to make an irrational investment move by selling the stock when the price was actually a bargain. I was frustrated and upset after seeing the stock I sold goes up in value years later, knowing that I would make huge returns if I have kept the stock. New investors worry if the stocks are too expensive while simultaneously fretting about missing out on market gain. The stock market price value fluctuates every day, and no one knows when the market will enter into a bear market or if the stock market is going to continue to going up. Peter Lynch, who is a successful fund investor, mentioned, “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.” What he meant by this is that it’s almost impossible to time the market.

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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