Hello Dear Reader,
I am going to give you a small introduction about this technique and the advantages it has.
What is that
Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases in an effort to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset's price and at regular intervals.
The below picture shows the price of S&P500 with blue, and with green it is the Simple Moving Average of the last 30 days (called 30-Days SMA).
It does not really represent the average cost you purchased S&P500 shares, but it helps to understand how this principle helps to filter out the "noise" in the price and reduce the overall volatility.
What it means for a portfolio
As you figured out, the portfolio wouldn't start from huge number, but steadily increase with time. This reduces risk, but also reduces the expected return.
Let's have a real life example by examining 2 portfolios:
All in - There is a fund of $11,500 which is fully allocated on S&P500 on January 1st, 2020.
DCA - The same $11,500 are split into $1,000 initial investment, followed by monthly contributions of $500, for the next 21 months.
Now let's look at the evolution with time:
In the above chart you can clearly observe that the "All In" portfolio has outperformed the "DCA" portfolio by about $1,700. However, you should also note that the blue line is much less fluctuating, meaning the portfolio behavior is less volatile.
In other words, what you get in return are well slept nights and less anxiety.
Here is a simple example of how I am going to use this technique:
Each month on 10th I will add about 5% equity regardless of market conditions. I will use this money to open trades on wide market ETFs, such as TQQQ, SSO, XLV, etc.
Why even experienced investors are doing that
2021 was a difficult year. Many investors were trying to time the market and sit in cash in an attempt to buy the future dips. But the show went on, and some of these investors were underperforming the overall market.
So, in order to make some money while waiting for dip opportunities on particular stocks, one could keep buying wide market ETFs, and get the wide diversification implicitly.
As further reading, I can recommend you the awesome book A Random Walk Down Wall Street by Burton G. Malkiel.
He describes this principle in one of the chapters, but there is also plenty of other useful content in it.
I hope this will be useful for your investment journey! Feel free to share you comments in the section below.
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