Dollar-Cost Averaging (DCA) – Explained
Dollar-cost averaging is sort of like a fool-proof strategy that most seasoned investors recommend. However, have you stopped to really think about what it really entails? Well, in this article, I will be explaining exactly what DCA is and how you can utilize this strategy to the fullest. You don’t have to be an advanced investor. I’ll break it down so that complete beginners can understand!
Let’s say you have some money right now and you want to invest in a particular stock or ETF, but the market conditions are looking shaky, and you have no idea where to begin. So, the ultimate question remains. Should you buy the stock right now? Or maybe split your purchases over-time? In this article, I’m going to answer just that.
TABLE OF CONTENTS
To put it simply, Dollar-Cost Averaging (DCA) is a risk management strategy so that you can invest your money in the stock market, without taking on excessive risk at any given point in time.
An investment of $100,000 in stocks using the Dollar-Cost Averaging strategy can be made over 12 purchases/weeks/months (depending on your personal circumstances) in subsequent order. Here’s an example that illustrates the trades for DCA strategy using Apple (NASDAQ:AAPL):
Dollar-Cost Averaging Example
In the table above, I’ve theoretically invested ~$10,000, in each category, into AAPL. The first table illustrates the results of Dollar-Cost Averaging (DCA); whereas the second table illustrates the results of lump sum investing. As you can clearly see, you’d fare much better if you utilized the Dollar-Cost Averaging strategy when investing in AAPL in early 2022. The DCA strategy performed almost twice as well (-10.55%), as compared to lump sum investing (-18.30%).
2022 hasn’t been a good year for the US economy thus far, where the S&P 500 had declined 18.7% (as of the writing of this article). Taking this into account, Dollar-Cost Averaging will be able to provide better returns as compared to lump sum investing, in order to minimize the risk of each investment.
a) It takes the emotion out of investing.
Using your emotions in investing could be one of the worst, if not the worst things that you can do. It affects your buying & selling decisions. Humans tend to be greedy when the market is at its peak and fearful when the market crashes. It’s totally natural, in fact, that is what you might call a “fight or flight” response.
b) No one can time the market.
There are only 2 outcomes whenever you buy into a stock: either it goes up or it goes down. Fund managers would argue that they are really good at market economics as they have different tools, market intelligence, formulas, as well as calculations to time the market. That’s true, only to a certain extent. There are many reports & studies, such as this one from CNBC, suggesting that almost 80% of active US Fund Managers underperform against the S&P 500 Index.
These fund managers have what seem like unlimited resources, proprietary information, huge teams, etc., and many of them could not outperform the index. If the majority of fund managers could not outperform the index, what hope is there for retail investors?
A vast majority of retail investors have full-time jobs and other commitments to attend to, which makes it even more difficult to outperform indices such as the S&P 500 Index that has an annualized return of 10.67% since its inception in 1957.
If you are still not convinced, there’s a really well-written article called “Even God Couldn’t Beat Dollar-Cost Averaging”, that I highly recommend for you to check out.
Here are some of the tips that I personally use to fully-optimize my DCA strategy. Do note that this is my personal preference and should only serve as a guidance, rather than the “best way” to DCA.
a) Dollar-Cost Average into Good Companies.
Personally, I would recommend Dollar-Cost Average to companies that I know will do well in the future. Always do your research before investing into any company. Projections and promises will likely differ from reality; therefore, data & facts will be crucial in this regard. If you’re looking for information for ETF investing, you can check out my other article here.
A “good” company to me, can be defined as such:
- Increasing Profits – Consistent profitability (ideally with growth) is one of the most crucial aspect of any business. Positive and growing free cash flows, earnings per share (EPS) etc. are some of the key ratios to measure a company’s profit.
- Low Leverage – Low leverage indicates that the company is able to generate profits while maintaining the profit margin without the need to be over-leveraged (i.e. take on too much debt), as that can put the company in a risky position financially. A general rule of thumb would probably be a debt to equity ratio of not more than 2.0.
- Has a Business Moat – To ensure that their products are well-received and has some proprietary quality that cannot be easily disrupted by competitors. Most successful companies like Apple, Google, Tesla and Amazon have a strong business moat that cannot be replicated easily by its competitors.
- Good Management – Crucial to the success of a business as the integrity, intelligence and adaptability of a business manager can determine the course of the company’s future. Think of the CEOs as your business partners – would you trust them to run your business?
b) Splitting the Investment into 3 Purchases.
This essentially means dividing your investments into 3 parts. For example, if you’re looking to invest $6,000 into Tesla (TSLA), try your best to split it into 3 increments, at $2,000 each.
- The first $2,000, will be what I call the “opening position”, this usually is at any price that I’m comfortable with, as long as it’s not at an all-time-high.
- The second buy (the follow-up) is usually initiated when the price dips 10-15% from my opening position. The 2nd $2,000 goes here.
- Lastly, the third buy (the discretionary buy) could potentially start depending on the situation. If it dips by another 10%, then I will put in the last $2,000. However, if it grows or if my cash reserves run low, I will usually hold the cash until it drops 15-20% from the all-time-high, or if it comes back down to a support line for a period of time.
c) 20% Cash Rule
The third rule is relatively straight-forward. I hold a 20% cash reserve, just in case, in the event of a market crash. If my cash reserves fall below that threshold, I won’t consider buying smaller dips in the event of a crash. Worst case scenario, I’ll have 20% cash to cushion the impact.
20% Rule – Cash Reserve Illustration
Why 20%? There is no right or wrong answer to that, it’s just my personal preference. This cash buffer can be used as a “safety net” for any potential bear market or market crashes, which is crucial in averaging down our investment cost price in order to reap the most benefit out of it.
When my cash reserve dips below the 20% mark, I tend to play it more conservatively – the market is always there so there is no need to fully deploy all of your cash all the time!
Well, that’s how I like to do Dollar-Cost Averaging myself. I do hope that you find this article helpful. When I first started my investment journey, I remembered that it was Graham Stephan that said something similar, which really got me thinking about my investments strategy.
If you can’t afford to split your purchases into 3 parts, then I’d highly recommend you to have at least enough capital to do a “follow-up” buy, just in case it dips 20-30% lower. If not, you’ll be missing out on the discount.
Be patient and try not to get FOMO (Fear of Missing Out). I know it’s hard, but if you have a limited disposable income for investing, then I’d try to avoid buying too many stocks. Honestly, sometimes, less is indeed more. It allows you to have the ability to streamline your investments and DCA if you have to. If you prefer to watch this in a video-form, you can take a look at my video that I have uploaded talking about Dollar-Cost Averaging!
Also, if you’re looking for a brokerage platform that you can easily DCA in, Interactive Brokers is a platform that I can confidently recommend to everyone. The platform is intuitive & the support is second to none. That being said, I do hope that you enjoyed this article & that you’ve learnt a thing or two!