Dollar Cost Averaging – the Improved Version


Dollar Cost Averaging is a common technique for investing that will result in better results than simply buying all at once much of the time.  In Dollar Cost Averaging (DCA), one invests a fixed amount of money on a regular basis. For example, an investor may put $1000 in a mutual fund every month regardless of market conditions or other factors. By fixing the amount, the effect is to buy more shares when the price is relatively low, and less shares when the price is relatively high; therefore, even if the market stays essentially flat, just moving up and down between a couple of limits, because more shares are bought at the lower prices, the cost basis will be below the average of the price range, so a profit will be made.

DCA can be automated.  Many mutual fund companies allow you to make regular automated deposits from your checking account.  For example, you can set it up where you send $200 every two weeks, right after you get paid, into the fund company to buy shares of a fund that you own.  Because the payments are made based on a fixed time-basis, regardless of what the market is doing, you will be doing DCA.  The nice thing about this strategy is that it is very easy – just set it up once and leave things alone.

DCA is a very automated, easy, no-decision way of investing that is a good approach. It can also be improved upon, however, without a lot of additional effort.  The reason is that while the movement of a stock over any given day are effectively random (you have about a 50-50 probability of the stock ending up or down on any given day), the more a stock goes down the more likely it is to go up, at least eventually.  This is because there is a fundamental value for a company based on the value of assets they own and their ability to make money.  The more a stock goes down in price, the more it needs to increase to return to this fundamental value.  It is very common for stocks to become undervalued during a sell-off as people let their emotions drive them into selling for less than the stock is worth just to get out without further losses.The modification to the dollar cost averaging strategy is therefore to wait for periods where the stock has fallen in price by a specific percentage before making investments. In doing so, a better price will be gained than that gained through blind averaging.

Choosing when to buy in this method is somewhat arbitrary. One could buy when the price falls for three days in a row, or when the price drops by 10% or so. This can be done without following the stock price constantly by setting limit orders 10% below the current price of the stock.  For example, if the stock were trading at $40 per share, a limit could be set at $36 per share.  By making the order “Good ‘Til Cancelled,” or GTC, the order would remain in place for a month and only need to be renewed if not executed within that amount of time.

Obviously a method should be chosen such that the stock can be bought regularly. Waiting for the price to drop by 20%, say, before making a purchase, may result in few shares actually being purchased while the stock climbs to the sky, leaving you behind.  Waiting for a 10% drop might also be too much – perhaps 5% would be a better limit for stocks that are not very volatile (meaning they don’t change in price very much just through random fluctuations).  And that is the danger in using this method.  The big gains in stocks are often had in a few days or maybe a few weeks, then the price will tend to tread water for a while.  If you wait too long for too good a price, you might see the company shoot through the ceiling while you are standing there with your money on the sideline.

In general trying to time the markets is a bad idea.  At least with this strategy, however, you’ll always have most of your money invested – you’re just holding back with the money you are adding to the position.  (I’m not suggesting selling out when the price goes up, just delaying purchases until a drop in price has occurred.)  You therefore won’t entirely miss out on the big gains – you just won’t do quite as well as you would have if you had been buying using DCA, where you bought shares even if the stock was in a big uptrend anyway.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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