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Dollar Cost Averaging is an investment strategy where the investor chooses to invest his capital into a portfolio based on three guiding principles:

1. There is a defined time period on which the investment is made, e.g. 10 periods

2. The invested capital is the same during each time period, e.g. $1,000 per period

3. The capital is invested on every defined time period, i.e. no period is skipped or missed

Based on these three guiding principles, we will invest the same amount of money into a pre-determined portfolio on every time period, e.g. on a monthly basis. This investment is made regardless of the fluctuation in price on the portfolio. In the following four examples, we will determine whether dollar cost averaging works as an investment strategy.

P.S. Read till the end for a real life application on whether it works! 🤓

Assumptions:

  1. Number of Periods: 5 years
  2. Capital for each period: $10,000
  3. We invest the same capital ($10,000) for each period (year 1 to year 5)
  4. All figures are rounded off to the nearest whole number

1. When the Price moves Downwards

When the Price moves Downwards
When the Price moves Downwards

Investment made via Dollar Cost Averaging

In our first example, the price of the portfolio is $10 at Year 1. With our annual budget of $10,000, we will purchase $10,000 / $10 = 1,000 investment units.

During the second year, the price of the portfolio is $8. In the same way, we are able to purchase $10,000 / $8 = 1,250 investment units.

We will repeat this process throughout the five years in the same fashion.

At the end of 5 years, our total invested capital is $50,000 and we will amass a total of 11,417 investment units. At the present time, our investment units are worth 11,417 units x $2 = $22,833.

Lump Sum Investment

On the other hand, let’s invest our total capital of $50,000 at Year 1. In this case, we will only be able to purchase 5,000 investment units ($50,000 / $10). Five years later, our investment units are only worth $10,000 (5,000 x $2).

Long-Term Outlook

In the long run, dollar cost averaging allows us  to purchase more investment units in the downtrend market. On the other hand, our loss is magnified by a lump sum investment at the beginning of the period. 🔍

Despite losing money in both scenarios, dollar cost averaging reduces our loss by a large margin. 🤕

Therefore, dollar cost averaging works in our favour in a downtrend market. 👍🏻

2. When the Price moves Upwards

When the Price moves Upwards
When the Price moves Upwards

Investment made via Dollar Cost Averaging

By repeating the same process (above), we will have invested $50,000 with 11,417 investment units at Year 5. While the total number of units stays the same (as example 1), our investment units are worth $114,167 now. (11,417 units x $10)

Lump Sum Investment

In contrast, we will have 25,000 investment units ($50,000 / $2) by performing a lump sum investment. As a result, our investment units are worth $250,000 now! (25,000 units x $10)

Long-Term Outlook

The longer the time period, the lesser the number of investment units that we can purchase through dollar cost averaging. On the other hand, our lump sum investment continues to balloon up into the sky. 🎈

Hence, dollar cost averaging does not work in a uptrend market. 👎🏻

3. When the Price moves Down, then Upwards

When the Price moves Down, then Upwards
When the Price moves Down, then Upwards

What if we combine the two trends together? Specially, we shall invest into a situation when the price of the portfolio moves downwards, and upwards thereafter.

Investment made via Dollar Cost Averaging

In this situation, we will have a total of 6,167 investment units at Year 5. Accordingly, our investment units are worth $61,667. (6,167 units x $10)

Lump Sum Investment

By investing a lump sum during the initial phase (Year 1), we will only have 5,000 investment units ($50,000 / $10). Consequently, our investment units are worth the same $50,000. (5,000 units x $10)

In the Long Run

As shown above, dollar cost averaging helps us to earn $11,667 ($61,667 – $50,000). This is despite the fact that the price of the portfolio is the same on Year 1 and Year 5. On the contrary, we will have wasted our time by investing a lump sum. 🤷🏻‍♂️

Therefore, dollar cost averaging works in our favour in this case. 👍🏻

4. When the Price moves Up, then Downwards

When the Price moves Up, then Downwards
When the Price moves Up, then Downwards

What if we reverse the trend – have you thought about this? Let’s find out if there is any difference when we invest into a portfolio when its price move upwards, and downwards thereafter.

Investment made via Dollar Cost Averaging

In this case, we will have a total of 6,833 investment units at Year 5. In similar fashion, our investment units are worth $41,000. (6,833 units x $6)

Lump Sum Investment

If we had invested a lump sum of $50,000 during the first year, then we will 8,333 investment units ($50,000 / $6). At the present time, our investment units will be worth $50,000. (8,333 units x $6)

In the Long Run

Through dollar cost averaging, we will suffer a loss of $9,000 ($50,000 – $41,000). 💔 By the same comparison, we will end up with the same amount of money if we had invested a lump sum at the beginning of time. While there is no gain, at least there is no loss! Phew! 😅

Hence, dollar cost averaging does not work once more. 👎🏻

What is it good for?

If you have understood the examples that we have discussed, you will have probably derive the same conclusion as me. That is to say,

Dollar cost averaging is not a foolproof and sure-profit investment strategy.

Instead, it is a useful and practical investment strategy if you

  1. Have a limited investing capital; 💵
  2. Prefer not to invest all of your capital at one go; 💰
  3. Are unsure of the market direction 📈📉

Remember when you hear friends that say

Don’t put all your eggs into one basket!

Similarly, the philosophy applies here. 🤓

Before I end this post, here is a real life application. See for yourself if it works. 😉

Dollar Cost Averaging: Real Life Application - AIA Regional Equity Fund
Dollar Cost Averaging: Real Life Application – AIA Regional Equity Fund

Disclaimer: Past performance is not and will never be an indicator for future performance.

Thoughts of the Day 💭

  1. Will you prefer to invest through dollar cost averaging or a lump sum?
  2. How will you reduce the investment risk?
  3. What do you invest in?

P.S. How do you create your budget? Here is how I do mine.


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