Sunday, May 24, 2009

Dollar Cost Averaging Pros and Cons

Hi folks. Time flew very fast and we have reaching the end of May. With the economy recession still in place, I believe our tough time might have some more time to go through. So good luck to all of us.

Today, I would like to touch on the an investment strategy, Dollar-Cost Averaging, or people used to name it 'DCA'. You might have already knew, dollar-cost averaging in fact is a popular investment strategy where you invest a fixed dollar amount at a pre-determined intervals. Simply say, when the markets are up, you buy fewer shares per dollar invested due to the higher cost per share. When the markets are down, you buy a greater number of shares per dollar invested. This strategy allows us to get an average cost per share over time, meaning you don't have to invest the time and effort to monitor market movements and strategically time your investments.

This is the DCA we talking about today.

Okay I think it's pretty clear what is DCA and how it works for now. Well, I believe you always told by brokers or unit trust agents that, if you invest fixed dollar amounts on a monthly basis regardless of price and theorectically, you'll come out with more shares for your investment, and you make more profits from this strategy. To be honest, I've using this strategy since year 2005 and I found out it does works under circumstances, but definitely it's not the best way to maximize my money.

According to Timothy Middleton, a writter of moneycentral articles, when the market is studied over long periods, dollar-cost averaging almost always produces lower returns than investing lump sums in diversified portfolios, and almost never reduces risk meaningfully. Calculation below are the evident he found:

Three ways to invest
Investment amount and fund net asset value by date

Lump sumDollar-cost averagingRandom
1/2/2004$3,000 at $25.94$750 at $25.94

$300 at $27.22

$300 at $27.12

$300 at $26.44
$750 at 26.75

$300 at $26.25

$300 at $26.36
$750 at 26.56

$300 at $26.25

$300 at $25.85

$300 at $26.29

$300 at $26.23
$750 at 26.65

$300 at $26.61
Closing NAV$28.55$28.55$28.55
Total investment$3,000$3,000$3,000
Value on 12/27$3,351$3,294$3,315
Total return11.7%9.8%10.5%
Notes: Vanguard Total Stock Market Index fund. As of 12/27/2004.

Assumes total investment of $3,000. Total returns include reinvested dividends as follows: 8 cents on 3/26; 9 cents on 6/25; 9 cents on 9/24 and 18.5 cents on 12/23.

Sources: Lipper, MSN Money, Microsoft Money

DCA always illustrated in capture lower prices along the way but finish nicely ahead.

According to Tim, what dollar-cost averaging has become is a salesman's tool to prize away in small increments the larger sum he couldn't talk you out of in the first place. But if that's what it takes to get you to invest, so be it.

Even Phil Town, the best selling author of Rule #1 - The Simple Strategy for Successful Investing in Only 15 Minutes a Week, also complaint about the costly myth of dollar-cost averaging. He emphasized on why we need to buy when there is high cost per share. Will it be better we only buy when the cost is low?

In my opinion, be it DCA, random or lump sum strategy, we only can maximize our investment when we aim at the right time, come with a goal or plan. Since everyone saying we cannot predict the market and most of the time it will goes up and down, it doesn't mean we cannot do anything with it but to stick with DCA strategy. Lump sum investment results in better returns most of the time, because you have the money in the market longer. This is based on the idea that the longer you have your money in the market, the better your returns are over the long run, as shown in the table above.

You should buy and read this book if you haven't.

So what's left for DCA? Indeed, it is affordable for people who treat investing like paying a bill or loan. Some people do not afford to invest $5000 at a time, but they managed to do monthly installment of $417! See, this strategy is being used in everywhere such as monthly installment for car, TV, notebook, EPF contribution, insurance etc. We talk about affordable & convenience here!

I think I've bull shit too much, as I believe you must be better than me on this already. In summary, as what old man said, the bottom line is, whatever strategy you apply, investing is better than not investing. Cheers. :)

1 comment:

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