Welcome to Finance and Fury. This episode will be explaining the dollar cost averaging strategy.
It seems to be a pretty simple strategy – but one hard to get right – so want to run through it and when to use it in further detail
What is a dollar cost averaging strategy – DCA for short
It is breaking up investment timing - Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount that they wish to invest across periodic purchases The aims of this is to reduce the impact of volatility on the overall purchase of investments in the short term It is the concept of taking out the short-term probability of market volatility from investment decisions It is a hard question – when to purchase an investment – today, tomorrow, or wait a few weeks and hope the price goes down The concept of DCA is to take this short-term guessing game out of the equation – if the market does down next month then great – through doing DCA you are picking up more investments at a lower price That is where nobody knows when the correct time to purchase investments will be – market volatility in the short term is anyone’s guess – In the long term – you can have a degree of certainty that investments values will be above where they are today – but in the short term – the truth is that it is anyone’s guess Due to the nature of the share market – demand and supply in the shorter term is outside of any fundamentals – you might have a great company based around fundamentals- but it lags behind in price – hence has a lower return But this strategy is meant to expand upon the single investment into a share holding into a greater range of investments In dollar cost averaging – you need to decide on two parameters the fixed amount of money to invest each cycle and the time horizon over which all of the investments are made For example – do you invest $100k over 10 months, at $10k a month or 5 months, at $20k p.m. The shorter a time horizon - the strategy behaves more like lump sum investing What is a DCA strategy in practice – the dividing up of a lump sum investment into incremental investments As an example – say you have $100k of cash or funds available for investment purposes - By dividing the total sum to be invested in the market - that $100k into equal amounts that you then put into the market at regular intervals - a DCA strategy seeks to reduce the risk of incurring a substantial loss resulting from investing the entire lump sum just before a fall in the market The amount to invest in the monthly increments can vary widely – you could invest $25k for 4 months, $10k for 12 months or $1k for 100 months There is massive variance in the number of monthly investments which can be implemented – can do anything from 2 to 1,000 months However - Dollar cost averaging is not always the most profitable way to invest a large sum If you are investing $100 each month for 1,000 month – you might be worse off then if you investment the $100k in month 1 This is due to the investment returns of the market versus the opportunity cost of holding these funds in cash If you think about it – what is the longer term expected returns of the share market – maybe between 8%-10% - so if you are holding the majority of these funds in cash this whole time period – you are missing out on returns This doesn’t mean you have lost money thought participating in a DCA strategy – it is simply that your returns wouldn’t have been if you invested all the money on day one – If you were investing $100 p.m. for 1,000 months – that is a little over 83 years – so you can see that this form of DCA will miss out on a lot of the potential returns As the concept comes back to minimising the risks of short-term volatility – whilst still trying to maximise on long term investment potentials The DCA strategy is all about minimising the potential downside risks of making investment from cash Cash is seen as a defensive asset class – no volatility in investment returns – Hence taking additional risks on from defensive funds does have additional risks – of which- the DCA strategy can help to minimise these The DCA strategy best works when the markets undergoing temporary declines because it exposes only part of the total sum to the decline – but that is where this become a guessing game – is the market going through a short term decline – or a structural decline? That is where the DCA strategy can shine – if the DCA is for 12 months- then most of the decline would have been purchased into So this technique is so called because of its potential for reducing the average cost of shares bought. But this strategy depends on the type of investments purchased As the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA possibly can lower the total average cost per shareof the investment, giving the investor a lower overall cost for the shares purchased over time The optimal DCA strategy is almost impossible to achieve – again there is no way to guess what the market will do in the short term – IF the market goes down – and you are going a DCA strategy – then great – you have made a good decision If the market only goes up – well then there are losses in investment potentials – If the market goes up, then down, then up – as is normally the case over a 6 month period – then there isn’t much of a benefit or a gain However – you have minimised the potential risks to the portfolio – that is where there is no guaranteed way to get positive returns But your probability of getting negative returns through losses is reduced through a DCA – Your probability of getting lower than market returns may be lower however – if the market is going through a bull market trend The pros – Volatility losses int the short term can be minimised – reduces exposure to certain forms of financial risk associated with making a single large purchase Can help to get you into the market – more behavioural – helps to get people into markets without delaying further due to worries of investing a large lump sum The cons - there is also evidence against DCA - there is an article published called "The superior long-term returns of lump sum investing [over DCA] have been acknowledged for more than 30 years." The weakness of DCA investing applies when considering the investment of a large lump sum as DCA would postpone investing most of that sum until later dates - Given that the historical market values tend to increase over time, starting today tends to be better than waiting until tomorrow DCA works best when investing into high growth portfolios – no point doing a DCA strategy into bonds The returns of DCA strategies can be sub-optimality – however it can be used as a behavioural tool that makes it easier for investors to start investing a lump sum allows investors to make a trade-off between the regret caused by not making the most of a rising market and that caused by investing into a falling market, which are known to be asymmetric helps people get used to investing as well – dipping toes into the water rather than taking a dive headfirst in – depends on the person Returns – One study found that the best time horizon when investing in the stock market in terms of balancing return and risk is 6 or 12 monthsMonths
Returns
Invest day 1
DCA 5 months
1
-2%
$49,000.00
$9,800.00
2
-2%
$48,020.00
$19,404.00
3
0%
$48,020.00
$29,404.00
4
2%
$48,980.40
$40,192.08
5
-4%
$47,021.18
$48,184.40
6
3%
$48,431.82
$49,629.93
7
3%
$49,884.77
$51,118.83
8
2%
$50,882.47
$52,141.20
9
1%
$51,391.29
$52,662.62
10
2%
$52,419.12
$53,715.87
11
1%
$52,943.31
$54,253.03
12
2%
$54,002.18
$55,338.09
Total returns
8.00%
10.68%
Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested is dependent on if the market is moving upwards or downwards over the DCA period of time I normally look at timeframes of 3-9 months depending on the amount of funds being invested Look at a few examples – if you have $50k to invest – DCA returns – However – if investments continue to go up - you have a lower investment – however not a loss of investment One key component of maximizing profits is to include the strategy of buying during a downtrending market, using a scaled formula to buy more as the price falls; then, as the trend shifts to a higher-priced market, to use a scaled plan to sell. Best ways I have seen this implemented – as well as what I recommend for clients – DCA strategy into a range of managed funds or ETFs to help reduce the market volatility and avoid any specific risks – instead you are DCA’ing into market specific risks Generally do it for risk adverse clients who don’t already own much in the way of investments – as well as doing it in time periods when there is a greater level of market uncertainty Misconceptions - {\displaystyle r={\frac {p_{F}}{{\tilde {p}}_{P}}}-1,}DCA is not the same thing as continuous, automatic investing. This confusion of terms is perpetuated by some articles and specifically noted by others Continuous automatic investment is more like lump-sum investing in that the investor invests the funds as soon as they are available, in contrast to DCA where the investor withholds available fund from the market. The pros and cons of DCA have long been a subject for debate Types of investments this works with – forms of index funds or managed funds – high growth investments that do have volatility Can be useful to use – to help reduce downside risks – can also be helpful to get into the market and gain experience and reduce delay from not investing fundsThank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
