We’ve been talking about different investment strategies like trend trading and the buy low and sell high strategy on previous articles. One strategy that has been mentioned last time was Dollar Cost Averaging. But what really is DCA? How effective is this strategy in improving investment profitability? In this article, we are going to talk about a way on how to effectively use DCA in investing.
What is Dollar Cost Averaging?
DCA or Dollar Cost Averaging is an investment strategy that aims to lessen the impact of volatility on large purchases of investments. It works by regularly investing a fixed amount of money on a particular security at a pre-set schedule regardless of the current share price. This strategy allows the investor to purchase more shares when their current price is low and fewer shares when their current price is high.
Again, there is no foolproof investment strategy that could completely eradicate the possibility that an investor will lose money on investments. Rather, DCA allows to accumulate investments over time instead of paying a large amount at once. It helps in buying investments without having to worry when the right time to enter the market is.
How effective is DCA?
You may hear investment advisors tell you how profitable DCA is. However, DCA is not recommendable all the time. The Dollar Cost Averaging strategy works best during volatile market times. We can break down the possible effects of DCA on the situation below.
An investor agreed to use DCA by automatically investing $5,000 per month on hypothetical Stock ABC. Assuming that the duration is 6 months, the result would be:
Month 1: $50 = $5,000/$50 = 100 shares
Month 2: $46 = $5,000/$46 = 108.7 shares
Month 3: $39 = $5,000/$39 = 128.21 shares
Month 4: $42 = $5,000/$42 = 119.05 shares
Month 5: $48 = $5,000/$48 = 104.17 shares
Month 6: $54 = $5,000/$54 = 92.59 shares
Based on the data above, the investor had invested $5,000 per month on Stock ABC regardless of its current price. Over the duration of the DCA, the investor was able to buy almost 653 shares for only $30,000. On the other hand, if the investor decided to buy 653 shares at the current share price of $50, the investor would have paid $32,650, which costs $2,650 more than the price paid through DCA. Thus, with DCA, the investor was able to buy 653 shares for an average price of $46.5 instead of $50.
You can notice that DCA works best when the share prices are volatile or unstable. It lowers the risk of paying a share with a very hefty price. The major downside of DCA is its selective effectiveness in the market. If the current market is going through a bull market, it is not advisable to adapt the DCA strategy. Instead, it would be better to invest at a one-time purchase as early as possible so as to ride up with the market trend instead of paying the same amount with fewer shares through Dollar Cost Averaging.
There are numerous strategies and techniques that could be used to increase investment profitability. However, not all of these can be used on all kinds of situations. Experimenting with different approaches and researching on the best techniques could help massively in securing good investments. That is why demo accounts are important to provide a platform in discovering new and lucrative strategies.
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