Dollar Cost AveragingApr 08, 2020
Can I Time the Markets? You can certainly try. But remember the expression: one man's ceiling is another man's floor.
When the stock market becomes volatile, people often wonder, Is this a good time to go in? Or should I sell out? What they are doing is trying to time the markets – they are making educated (or emotional) guesses as to market peaks and valleys, and investing accordingly. I’d put it to you that market timing doesn’t work, at least not consistently over time. If you look at a line graph in the first quadrant, there is nothing to say that the next data point will be above the last point, at the last point, or below the last point. Trends are real and visible, but they change.
We certainly understand the impetus behind market timing. You as an investor don’t want to put your money in on what turned out to be a high day for the year, and conversely you don’t want to have sold at what was the low day for the year.
The Idea Behind Dollar Cost Averaging
The idea behind dollar cost averaging, or DCA, is a simple one: Instead of trying to time the market you invest a pre-determined amount of money according to a pre-determined schedule. This means that you automatically buy more shares when prices drop, and conversely fewer when prices rise. When you compare the higher and lower share prices you’ve paid over time with the number of shares you’ve accumulated, you should see an interesting trend develop: your average cost per share is lower than the mean average price per share during the same period.
Here's How It Works
Here’s an example. Say you invest $100 a month into a single mutual fund, over four months.
- Month 1, the price is $10/share, and you purchase 10 shares
- Month 2, the price is $12/share, and you purchase 8.33 shares
- Month 3, the price is $14/share, and you purchase 7.14 shares
- Month 4, the price is $8/share, and you purchase 12.50 shares
The result: over 4 months you have invested $400, and purchased 37.97 shares. Your mean price per share is $11.00 ((10+12+14+8)/4). Using that mean price you would have purchased ($400 / $11.00) 35.36 shares. Instead, however, you purchased 37.97 shares, making your average cost per share ($400/37.97) $10.53/share – lower than the arithmetic mean of $11.00 by $.47. The result is you’ve purchased 2.61 additional shares. Do this over a number of years, and the results are significant.
DCA for Lump Sums
Dollar cost averaging can also work to your advantage when you have a lump sum to invest. Say you sold a business, or came into an inheritance. DCA the funds over a period of months into your brokerage account to lower your average cost, as in the example above.
How About DCA for Sales?
Say you’ve held XYZ stock for a long time, and are sure it is near its peak. You want to take some gains off the table, but don’t want to miss any further upside movement. There’s nothing to say that trades must include the entire position! Sell 20%, and then wait a month. Maybe the stock has continued to rise a little, so you sell off another 20% at that time. For some reason investors tend to think of their positions as all in or all out, when the reality is that selling out of a position over time may mitigate a lot of risk.
The other consideration for sales is taxes. If you’re in a non-qualified account, meaning a taxable account, then the timing of sales can be crucial. Any sale will create a taxable event. Toward the end of the year you may want to do tax harvesting – match gains with losses, to lessen the capital gains tax burden. You may also want to hold a position until is is more than one year old in order to change the taxation on the gain from ordinary income to capital gains.
Dollar cost averaging does not guarantee a profit, nor does it protect you from losses. It is, however, an excellent investment discipline for investors whose time horizon is long. Market timing may work here and there, but remember that the tortoise beat out the hare.
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