A 101 on Dollar Cost Averaging by Amit Raizada
DCA, or Dollar Cost Averaging, is a very conservative type of investing strategy. It is designed to reduce risk by making stock or fund purchases spread out over time. With this strategy, an investor commits a set amount of funds on a scheduled basis to by specific types of investments, no matter what the share price is. If the price is high, then you won’t buy as many shares, but if the price is low, you will buy more. According to investment strategy experts like Amit Raizada, this strategy helps to prevent people from making risky, lump sum investments. Essentially, it is more similar to contributing to a 401(k) on a monthly basis.
But does it work? A DCA can be beneficial if you don’t like risks. However, you have to make sure you have a grasp of how you can get the best results. A DCA is supposed to be a long term, low maintenance strategy. You don’t have to constantly monitor the markets with a DCA strategy. However, you do have to time your market when you first embark on the strategy.
When you start to choose the funds and stocks you are interested in, you must make sure they are at a reasonable value. You cannot, at any point, cut your losses, so you have to be quite sure. Hence, you must look into trends for price-to-earning and the history of the company to make sure you are making a good investment.
Also, you have to make sure that you invest in a diverse portfolio. This will lower the risk even more. If you like the concept, but you think a DCA is too restrictive, there are a few variations possible, which allows you to hedge according to your personal preferences.
Variation 1 – Value DCA
Here, you will invest more when you experience a negative return month, and less after good return months. This means you can pick bargain value stock under the assumption that a rebound will take place. This focuses on the ‘buy low sell high’ adage. However, it can backfire as well if you constantly sell bad stock.
Variation 2 – Momentum DCA
This is the complete opposite of a value DCA. This means you invest more when the market is positive, and less when the market is negative. You assume, therefore, that the momentum of the stock price will continue on a short term basis. However, you could miss a real bargain, or you could have lots of greatly overvalued holdings.
If the market is a bull market, you will see that any lump sum investment would have done much better than any type of DCA. However, you have to think about the future as well, and whether you are purchasing in a market that is overvalued. If you find valuations are high and you don’t have a long time horizon, then a DCA would work better.
So which philosophy is best for you? It all depends on how much risk you can take and what your goals are. If you are aggressive with your investments and you want maximum returns regardless of the risk, then a DCA is not for you. However, if you want to have a secure investment with low risk, then choosing DCA is the best strategy.
If you do opt to invest in a DCA strategy, you have to keep the basic rules in mind at all times: do not forget to diversify and make sure that you choose the right types of investments. Regardless of what strategy you choose, it will always fail if you pick stocks that are poor performers or that are significantly overvalued.