Dollar Cost Averaging
A buy-and-hold investing strategy that has never served me wrong is the Dollar Cost Averaging (DCA) method. The name implies exactly what it is, a means of averaging out the acquisition price of your stocks.
Buying stocks at once in lump-sum exposes you to greater risk. You might buy 10 shares of a stock worth $100 each in January. A few months later, the stock drops to $55 each. Since your total cost-basis was $1,000, and the value of stocks after those few months was $550, you have an unrealized loss of $450.
Conversely, let’s suppose you buy 1 share of the stock each month, for 10 months. It’s valued at $100 in January, but drops $5 each month. Your cost-basis each month is as follows:
January – 100
February – 95
March – 90
April – 85
May – 80
June – 75
July – 70
August – 65
September – 60
October – 55
You now own 10 shares, at a total cost basis of $775. Since the stock kept going down, your position is now worth $550, but you’re only down $225 as opposed to the $450 in the former method. This is the value of dollar cost averaging. While you may argue that if the stock had went up instead of down, you would have been better off lump-sum investing rather than the DCA method, it is the ideal strategy for the “better safe than sorry” mindset. Since timing the market usually rarely works in our favor, the DCA strategy is your best bet to reap in rewards while mitigating volatility exposure.
Another way to visualize DCA is to imagine how a 401K plan works, if you have one. Funds of your choice are purchased with relatively the same contribution rate each pay cycle (deducted from your gross income). So in effect, by purchasing funds at market price every 2 weeks with the same dollar amount contribution, you are dollar cost averaging your investment elections throughout the year. When stocks do well, your portfolio value is higher. When stocks do poorly, your portfolio value may decline but you also get the opportunity to purchase your next round of funds/stocks at a lower price as a result. There is always an upside with DCA, as long as you train your psychology to acknowledge this.
Have you ever used DCA, or do you use a 401k? What are your thoughts on this strategy?