I’m fairly new to the world of hands-on investing. I’ve been contributing regularly to my RA and company Pension-fund over the years but I only recently started delving into the nuts and bolts of investing. I started reading a lot of books, articles and blog posts about personal finance, money and investing and learned a lot! One important concept I came across that I find crucial to understand for any hands-on investor, is what is called Dollar Cost Averaging (DCA), or as we in South Africa call it, Rand Cost Averaging (RCA). I want to delve into this idea a little more here.
There are basically two scenarios where Dollar Cost Averaging comes into play:
- When I invest a big lump-sum / inheritance
- When I invest a portion of my salary
When I invest a big lump sum / inheritance
The question comes up quite often. When receiving a big lump sum of money, do I put it all into the stock market at once, or do I spread it out over a set amount of payments and Dollar Cost Averaging it into the market? Which approach is the best?
The answer to this question is: It depends. Why, because there are different factors at play here. If we look purely at the financials and calculations, it makes sense to put in everything at once and let it ride the market. The reason for this is because, even though the up/down movement in the market is basically random, we know that over time the market tends to go up more than it goes down. Consider that between 1970 and 2013, the market was up 33 out of 43 years. That’s 77% of the time. So getting your money into the market as soon as possible and letting it start to take advantage of this upwards trend as quickly as possible makes sense, financially.
The flip-side to this answer is the emotional aspect. We’re all human. We know that if we put everything into the market today and the market crashes tomorrow, we’ll have a really hard time justifying that move to ourselves!
The odds of a market crash the day after your big deposit is very slim, but we still have emotional doubts and fears, so the real question is: what will make you sleep better at night?
What approach will best suit your personality and appetite for risk-taking? Only you can answer that question. The bottom line is that, from a pure financial approach, Dollar Cost Averaging is not a good idea when investing your lump sum.
When I invest a portion of my salary
This is really the type of Dollar Cost Averaging I want to investigate here, since this is the type most of us deal with personally on a regular basis. And this is the type of Dollar Cost Averaging that helps you build your wealth faster over time!
I make monthly contributions to my RA (Retirement Annuity) and TFSA (Tax-Free Savings Account). This is purely from a practical perspective, since I can only invest monthly as and when I recieve my salary at the end of every month. But what benefits do I have for doing this?
- I pay myself first. I make my monthly contributions immediately after receiving my salary and don’t wait until the end of the month to try and invest what’s left.
- So it creates a habit of forced saving.
- It also allows my money to get into the market as soon as possible to start the work of growing (as mentioned above, the market goes up more than it goes down, so this takes advantage of the upwards trend asap!)
- It eliminates Myopic Loss Aversion
- There’s also an interesting mathematical benefit of Dollar Cost Averaging your money into a volatile market. It gets you more bang for your buck! Let me explain, because this is where it gets interesting!
It builds wealth!
If there was no market volatility, a stock’s price would stay the same. For example, let’s say Company XYZ’s stock price is R10. If you invest R100 every month, you’ll purchase exactly 10 shares every month (exclude any brokerage costs, etc for this example). After 4 months you’ll own exactly 40 shares.
Now, imagine the market fluctuates up and down over this period, but overall, after the 4 month period, the stock price averaged the same R10. Say it was R10 in the first month, R15 in the second, R10 in the third and R5 in the forth month. In month 1 you bought 10 shares, in month 2 you bought only 6.667 shares, month 3 you got 20 and in month 4 you again bought 10. In total you ended up buying 46.667 shares (see table below).
So you received 6.667 shares more for the same total R400 investment! The secret here is to keep buying in down markets, because that’s where you get the shares “on sale”!
Dollar Cost Averaging forces us to buy when markets are down, which is usually the time when people don’t want to buy.
So as you can see, when Dollar Cost Averaging into our investments – relentlessly, in up AND down markets – we build wealth very efficiently.
If we understand this benefit, we also tend to embrace market volatility, instead of fearing it!
Until next time, happy investing!