Say you have just inherited $100,000 and want to invest it in a stock.
However, you are worried if you invest it all today, it might drop by 20% tomorrow (or next week, or next month).
Then you’ll be down to $80,000 and feel like a dummy.
This is a normal concern.
Nobody wants to see their hard-earned money get wiped off their screen in a matter of days or weeks.
This is what dollar-cost averaging (DCA) protects against.
Dollar-cost averaging is exactly what the name suggests:
You average the cost of your investment over a period of time, instead of investing all at once.
Say you want to invest your $100k in Starbucks stock.
Instead of buying $100,000 of stock today, you would instead invest on a timetable such as:
- January: $10,000
- February: $10,000
- March: $10,000
- April: $10,000
- May: $10,000
- June: $10,000
- July: $10,000
- August: $10,000
- September: $10,000
- October: $10,000
There’s a lot of flexibility with this strategy. It doesn’t have to be so uniform.
If you think Starbucks stock is cheap right now, you could skew it towards the beginning:
- January: $30,000
- February: $20,000
- March: $10,000
- April: $8,000
- May: $8,000
- June: $8,000
- July: $8,000
- August: $3,000
- September: $3,000
- October: $2,000
This allows you to invest the bulk at lower prices, but still protects in case it dips even lower.
Dollar-cost averaging works well for most, especially because most people don’t have big sums of money lying around to invest.
People get paid fortnightly/monthly, so dollar-cost averaging comes naturally – as you can only invest as funds become available to you anyway.
A good example of this is the Starbucks Experiment I’ve been running the public portfolio:
Every week I buy $3 of Starbucks stock (each dot represents a buy).
You can see Starbucks has bounced between $70 and $125, but since I’ve been buying at regular intervals (i.e. dollar cost averaging) this hasn’t affected our investment much.
Of course if I had made one big purchase at $70 my return would be much better, but if I had made a big purchase at $125 I would be in a big loss.
Dollar-cost averaging removes this risk and simply gives you a stable return over a long time period.
Average in, average out
Just like you can DCA into a stock, you can also DCA out.
For example, say Starbucks stock has a few good years and climbs to $200 a share.
We think this is a bit overvalued and it would be a good time to take some profit.
But what if we sell all our stock at $200, and then price goes up to $250?
We’ll have lost a chunk of potential gains.
To minimize this risk, we can dollar-cost average out of the position.
Say our initial $100k investment has grown to $200k.
We decide to sell 10% every month until our position is back to $100k.
So in the first month, we’ll sell $20k (10% of $200k).
Now our position is worth $180k.
Between Month #1 and #2, assume Starbucks continues to rally and our $180k grows to $190k.
In Month #2, we’ll sell another 10%, which is $19k (10% of $190k).
Our position is now down to $171k.
Between Month #3 and #4, say our position falls in value to $160k.
We’ll sell another 10%, which is $16k.
Our position is now down to $144k.
Between Month #4 and #5, say our position falls to $120k.
We sell another 10%, which is $12k.
Our position is now $108k.
Between Month #5 and #6, say Starbucks stock rallies again and our position grows from $108k to $120k.
We sell 10%, which is $12k.
Our position is now back to $108k.
In total, we’ve sold $79k worth of stock, and still have a position worth $108k.
This method of DCA’ing out of the position means we didn’t have to worry about timing our exit perfectly, and instead we could calmly reduce our position over a longer time period.
Of course, the above is just an example and you could stretch this out for a few more months or even several years, depending on your goals.
Remember – in investing, before we think about how much money we can make, we are always trying to protect our downside.
While DCA means you might give up some potential gains, it also allows you to reduce your risk significantly, while also making the mental side of investing much easier.
Less stress, less anxiety, following a simple game plan and sleeping well at night – all very important things that will make your life as an investor exponentially easier!
