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Dollar Cost Averaging – the Improved Version

Posted on the 14 October 2014 by Smallivy

Dollar Cost Averaging is a common technique for investing that will result in better results than simply buying all at once much of the time.  In Dollar Cost Averaging (DCA), one invests a fixed amount of money on a regular basis. For example, an investor may put $1000 in a mutual fund every month regardless of market conditions or other factors. By fixing the amount, the effect is to buy more shares when the price is relatively low, and less shares when the price is relatively high; therefore, even if the market stays essentially flat, just moving up and down between a couple of limits, because more shares are bought at the lower prices, the cost basis will be below the average of the price range, so a profit will be made.

DCA can be automated.  For example, many mutual fund companies allow you to make regular automated deposits from your checking account.  For example, you can set it up where you send $200 every two weeks, right after you get paid, into the fund company to buy shares of a fund that you own.  Because the payments are regular, regardless of what the market is doing, you will be doing DCA.

DCA is a very automated, easy, no-decision way of investing that is a good approach. It can also be improved upon, however, without a lot of additional effort.  The reason is that while the movement of a stock over any given day are effectively random (you have about a 50-50 probability of the stock ending up or down on any given day), the more a stock goes down the more likely it is to go up, at least eventually.

Looking at the chart for any stock, one sees that the price tends to increase for periods, then decrease for periods. For a stock in a company that is growing (the kind recommended here), the long-term lows (measured in periods of a few months) will always be higher than the previous lows, and the highs higher than the previous highs – this is called an “uptrend”. Because the stock does not move randomly, as it falls in price it becomes more and more likely that it will stop falling and move upwards again (again, we’re talking about stocks that over the long-term are growing). The stock therefore becomes more of a deal the further it falls.  The modification to the dollar cost averaging strategy is then to wait for periods where the stock has fallen in price before making investments. In doing so, a better price will be gained than that gained through blind averaging.

Choosing when to buy in this method is somewhat arbitrary. One could buy when the price falls for three days in a row, or when the price drops by 10% or so. Obviously a method should be chosen such that the stock can be bought regularly. Waiting for the price to drop by 20%, say, before making a purchase, may result in few shares actually being purchased while the stock climbs to the sky, leaving you behind.

And that is the danger in using this method.  The big gains in stocks are often had in a few days or maybe a few weeks, then the price will tend to tread water for a while.  If you wait too long for too good a price, you might see the company shoot through the ceiling while you are standing there with your money on the sideline.  In general trying to time the markets is a bad idea.  At least with this strategy, however, you’ll always have most of your money invested.  (I’m not suggesting selling out when the price goes up, just delaying purchases until a drop in price has occurred.)  You therefore won’t entirely miss out ont he big gains – you just won’t do quite as well as you would have if you had been buying using DCA, where you bought shares even if the stock was in a big uptrend anyway.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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