Should You Use Dollar Cost Averaging When Investing?
I was first introduced to the concept of Dollar Cost Averaging (DCA) when I was new to investing. At that time, I thought DCA sounded logical for it denotes the idea where investing should be viewed as a long-term activity to increase one’s wealth and not as a speculative activity to make a quick buck.
Before I move on, let me briefly explain the key concepts of Dollar Cost Averaging:
What is DCA and How it Works?
Dollar Cost Averaging is an investment method which involves the following:
- You pick an investment, be it a stock, a mutual fund, an ETF … etc. Let’s use a stock known as A Ltd as an example.
- Let’s assume that you are able to save $1,000 a month to buy shares of A Ltd.
- In Month 1, A Ltd was trading at $ 1 a share. Thus, you purchased 1,000 shares of A Ltd with $1,000.
- In Month 2, A Ltd’s stock price has fallen slightly to $ 0.80 a share. Thus, you purchased 1,250 shares of A Ltd with $1,000.
- In Month 3, A Ltd’s stock price had risen to $ 1.25 a share. Hence, you’d purchased 800 shares of A Ltd with $1,000.
- In the 3-month period, you had invested a total of $3,000 to purchase a total of 3,050 shares of A Ltd. Thus, your investment cost per share of A Ltd is $ 0.984.
|Period||Month 1||Month 2||Month 3||Total 3 months|
|Investment Amount ($)||1,000||1,000||1,000||Total: 3,000|
|Stock Price ($)||1.00||0.80||1.25||Avr: $ 0.984|
|Shares Bought (No.)||1,000||1,250||800||Total: 3,050|
- At the end of Month 3, A Ltd is trading at $ 1.20 per share. Hence, your shares are worth $3,660, giving you a capital gain of 22% in 3 months.
In short, DCA encourages investors to:
- Put aside a fixed amount of money to invest in an investment product.
- Invest in a specific frequency, be it monthly, bi-monthly, quarterly, and annually.
- Avoid timing the market. Buy more if its price drops. Buy less if its price increase.
- Be long-term focused when investing.
Who recommends DCA?
Commonly, it is introduced by financial planners (or salespeople) when they are introducing mutual funds for long-term investments or retirement plans.
This is because they (especially the mutual fund companies) want to secure you as their long-term customer.
Mutual fund companies made themselves rich today by promising you a better retirement in the future (which may or may not when the time comes).
If you invest in a mutual fund by Dollar Cost Averaging for 10, 20, or 40 years, the company earns sales charges (on a regular basis) and yearly trustee & management fees for the next 10, 20 or 40 years … beginning on the first day you invested your first dime into it.
So, am I saying that mutual fund companies are scammers?
My intention is to point out that mutual funds are set up by the rich. They have different ideas about investing than the middle class (or the working class). The rich invest for cash flow. The rest invest for capital gains.
Think about it.
Do most people who invest in mutual funds intend to enjoy capital growth or to collect distributions (passive income)?
I bet the former is the more likely answer than the latter.
Is DCA a Safer Approach to Investing?
I don’t think so.
Some claimed that DCA is safer because it is able to minimise your loss through averaging your purchase cost of an investment. To me, it made sense. But only, to a certain degree. I think DCA has also limited your gain for you had averaged your purchase cost of an investment. As you can see, DCA works both ways.
More importantly, I believe most people fail to realise the following when using DCA in investing:
- The Quality of an Investment.
Look! If you are investing in a stock, a mutual fund, or an ETF which are poor in fundamental quality, DCA is not going to make you money or to bail you out of your investment mistake. Rather than focus on DCA, it is more practical to first assess the fundamental quality the investment as normally, that is the ‘money-maker’ for investors (not DCA itself).
- Makes No Sense to Invest if the Investment is Expensive
Why would you want to invest if the investment is overpriced? To me, it makes no sense. DCA is not an insurance for investment folly. Instead, it is more practical for investors to learn how to value an investment prior to investing into it. That is why savvy investors calculate valuation ratios before investing into any stock.
Proposing a Better Approach – Value Cost Averaging
With that being said, I still believe that DCA has merits such as the approach of investing to be a long-term and regular activity to increase wealth. Therefore, I incorporated its merits and combined it with value investing principles to come up with a more practical investment approach – Value Cost Averaging (VCA).
Here is how it works:
- First, you studied a stock, B Ltd. You found it to be a good stock to hold and accumulate over the long-term.
- You are capable of saving $1,000 a month for stock investing.
- You set a target price for B Ltd, which is $ 1 a share.
- You went on to study 19 more stocks and thus, having 20 stocks in your watch list. You have set target prices of every single one of them.
- In Month 1, B Ltd is trading at $ 0.95 a share. You went ahead to buy its shares with $ 1,000.
- In Month 2, B Ltd is trading at $ 1.15 per share, above your target price. In this case, you don’t buy B Ltd. Instead, you find other stocks to invest from your watch list. If there is a stock that made the cut, congrats! You may go ahead and invest into it.
- If none of the stocks made your cut, then, you may place $ 1,000 into a fixed deposit account as reserve funds. They may come in handy in the future.
As such, Value Cost Averaging fixed two problems of Dollar Cost Averaging :
- Focus on Fundamentals
You invest only if the quality of an investment is good, thus, eliminating needless investment mistakes which cost you money.
- Buy Only if The Price Make Sense
You may set your target buying price by using valuation ratios. You may practise this in all asset classes, stocks or real estate. Unlike DCA, VCA is one that encourages common sense in investing for it refrains you from investing into anything that is overpriced and thus, boost your ROI.
Personally, Value Cost Averaging had served me well. Hopefully, it will be helpful to you too. And how do we determine value?