A Detailed Analysis of Dollar Cost Averaging
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If you are a stock market regular, it is unlikely that you have not come across the word Dollar Cost Averaging. I am sure at times you have even felt the urge to incorporate it in your overall trading strategy. A bit too many people might have suggested to you that it is one safe bet to minimize the risk on your investment and safeguard against future volatility. Sometimes you might be convinced but at many occasions you have had that doubt about its actual efficacy. So what exactly is this dollar cost averaging or constant dollar plan and how beneficial is it to an average investor?
What Does Dollar Cost Averaging Mean?
In very simple terms, it means a technique which advocates buying a specific share on a regular basis for a fixed amount of dollars irrespective of the movement in the price. As is expected more shares are bought for the same number of dollars when the share price is lower and the vice versa happens when the share price increases.
The essential thought that governs this strategy is that the average share price will become lower and lower with the constant increase in total number of shares held by an individual. Thus, the risk associated with committing a significant amount of money is a specific share all at once and perhaps at the wrong time is eliminated to a great extent with this strategy. If you are in United States, once you set up a 401(k) account it automatically transfers money there from your salary, so you end up using dollar cost averaging even if you don’t want/understand.
This is also a wise way to preserve your capital in case of a sharp fall in the market. In case of a severe fall in the market, investors tend to get into panic selling mode and book losses. But if the relative exposure is limited the extent of panic is also much lower. As a result instead of straightaway running from markets, investors take a more pragmatic view and are able to deal with the situation a lot more candidly.
Does Dollar Cost Averaging Indeed Help?
So now we transcend from the theoretical realms to the real world and the question is, does dollar cost averaging really work? Is it beneficial in real terms? Theoretically, it seems a perfectly logical deduction but how sensible it is in reality?
Comparison of actual market data throws up conflicting picture depending on the market and the dollar movement. A lot of times for totally unrelated news, there could be a huge downward spiral in the dollar exchange rate or perhaps in the market as such, and the essential balance between returns and risk gets skewed.
Some studies indicate that for dollar cost averaging to yield favorable results the time for investment should be ideal between 6-12 months. However, if one is really keen about maximizing the gains then additionally investors need to employ a strategy that helps them to pump in more dollars during a low in the share price or overall markets. Once the selloff eases, and the upswing begins, it would be time to use this same strategy to book profit by selling your position and thereby adding to your overall gain trajectory.
Some financial market experts also feel that dollar cost averaging automatically minimizes exposure to risk because the entire money never committed in one go and is rather in tranches but other debate saying that it is essentially a marketing ploy without any proven or consistent gain strategy for the investors. They opine that there are too many variable and thus the uncertainty too is way more than anticipated. They see it more as a trade-off by investors who are unable to anticipate a rally or are too scared of being able to recover in case they are stung buy a powerful bear phase. Whether or not investors do a dollar cost averaging, consistent investment in the market over a point of time is bound to yield results.
Concerns About Dollar Cost Averaging
Several debates among market experts and renowned investors have indeed highlighted some areas of concerning in employing the dollar cost averaging method for investing in the markets. The option to invest lump sum especially in a situation where the indications of a rally are quite distinct would enable the investor to book greater profit in one go. You must understand that DCA or dollar cost averaging because of its sheer nature will slow down the pace of profit just like it slows the extent of losses. In choosing to delay the extent of investment to a future date, the investor’s choices are really minimized and can actually work against his interest.
Given the nature of gains in the market anecdotally, many a times especially in the bullphase, it works much better to put your money to work today than wait for a later date. Even if you see the last few fall in markets, you would realize that given the frail economic condition, it is very unpredictable what can lead to a sell off and how long it might last, so if you have the appetite to take risk, it is best to make hay while the sun shines. The policy of continuous and automatic investment in the market regardless of the trade direction I would say is often a naive approach. Given the easy access to information and technology, in today’s era it is more of a gamble to wait for a better tomorrow instead of making your today better and richer.
In very simple terms dollar cost averaging has its benefits only where a lump sum or a one-time investment is out of question. If you actually believe in a systematic investment plan, then too instead of dollar cost averaging, regular exposure via ETFs depending on the market movement or a diversified exposure across asset classes will work as a better insurance of your investment than dollar cost averaging.
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