Dollar Cost Average: Stay away from Predicting

The truth about making money in the stock market is buy low and sell high. Quite simple eh ! But hold on, how do you really know when the market has hit bottom ? Can an investor really predict the bottom ? As a matter of fact hedge fund managers, mutual fund managers, private investment managers, market gurus, CEOs and analysts can’t predict the bottom, nor can you and me. So how should we approach this problem ? It is actually a tough one. Predicting if the market has reached its bottom it not that simple. However using the Dollar Cost Average investing technique, you could protect yourself in a falling market. Let us learn how.

What is Dollar Cost Average (DCA)
Dollar Cost Average is simply putting a X amount of money each month into an investment such as a stock, index fund or mutual fund. Most banks will even set up a monthly automatic-withdrawals service. Dollar Cost Average is also ideal for the investor who doesn’t have that big lump sum at the start but can invest small amounts on a regular basis. For instance, instead of investing a lump sum in one stock immediately, you might invest $2,000 in that stock at the beginning of every month.

Let us paint a scenerio
Let us say you have $5,000 to invest. Instead of investing the lump sum into a security, you decide to use DCA and spread the investment out by investing $1,000 a month for the next five months. This averages the price over five months, so some months you may buy fewer shares, each at a higher price, and some months you may buy more shares, each at a lower price. If the market is lower this month, you may lose money on the shares you bought last month, but this month you receive more shares, which, in the future, will help offset any losses. With DCA, you are able to take advantage of any low during these five months, guaranteeing you to invest at the very bottom because when it comes, you are simply doing what you do every month. Once the market turns around, which it is likely to do in the long term, you’ll be ahead.

For example:

Month

Investment

Price/Share

No. of Shares

Profit/Loss

Jan

$1000

$10

100

$0

Feb

$1000

$5

200

– $500

Mar

$1000

$8

125

+ $400

Apr

$1000

$10

100

+ $1250

May

$1000

$12.5

80

+ $2562

From the table above it is clear that using DCA, you end up making $2,562 as compared to $1,250, had you invested in lump sum.

Benefits of Dollar Cost Average

  • Reduces average cost per share: When you invest a set amount of your money each month, you buy fewer shares when the market is high and more shares when it’s low. This reduces the average cost per share which eventually will help you gain better overall profits as the market increases over the long term.
  • Reinforces disciplined investing: Dollar cost averaging requires the discipline to invest consistently, regardless of market fluctuations, which reinforces the habit of regularly setting aside money for investing.
  • Market trend: The markets, even though they have bad days or even bad years, tend to go up over time. With dollar cost averaging technique, it is very likely you will go ahead in the longer run.
  • Reduces fear of investing: Fear of investing at a market high can keep most investors waiting on the sidelines. With a dollar cost averaging program, you just follow the plan and invest on a periodic basis, without trying to time the market.
  • No need to predict: You do not have to do any predicting! If you were to try to forecast the bottom, you could miss it altogether and risk putting your entire investment in at a bad time.
Conclusion: Next time you hear of a forecasted bottom, you can be confident that he or she is no more insightful than you no matter who the individual is. No person can predict market behavior. But you can be rest assured that if you use dollar-cost averaging, you are being prudent. Dollar Cost Averaging not only offers protection from market swings but also helps you can take advantage of the ever-elusive market bottom.
  • DCA is a term that is mis-used. it should be ‘periodic saving’ instead.

    buying the same stock as it goes down is a sure fire way to lose your shirt. Imagine DCA’ing cisco as it dropped from $80 down to $10 at every $10 interval.

    your average price is now $45 and after 6 years you’re still underwater.

    Its a fallacy the financial media wants you to believe.

  • sJ

    True and not true. You are painting a worst case scenerio. I am painting a moderate level scenerio.

    The advantage of DCA is you get away from predicting the bottom. When you know the stock has fallen to an extent you feel is the bottom, using DCA technique you can buy it in smaller chunks rather putting lump sum.

  • DCA is effective only when investors have ample amounts of money to invest. And it’s applicable generally with value-oriented investors. Beyond these two drawbacks, I think it’s a great strategy.

  • Anonymous

    Just wanted to say that it is better to DCA into Cisco as it drops from $80 to $10 than to buy it all at $80. You have more shares for your money which means that if it bounce back, you would make more money. Even if it only returned to $60 instead of $80, the DCA-er would profit.

    Of course nobody should have bought Cisco at $80, and we should not expect any method of taking a long position to do well if the stock drops drastically and permanently.

  • Dollar Cost Averaging (DCA) is a nonsensical term. You might as well say “spoon yellow sky” and have it mean whatever you want it to. The better term that is self effident in it’s meaning is “Periodic Interval Investment” or PII. Most investment professionals will use “PII” now in lieu of DCA so that the meaning is clear.