I would like to know what is the mechanism of the cost averaging strategy? Do you want to know about its effectiveness before you start using it? Suitable for beginners? What are the important points to consider?
Cost averaging (abbreviation DCA dollar-cost averaging) is a well-known strategy. An investor can purchase target assets with a specific frequency, regardless of how much they cost. That is, the investor ignores the market situation and does not have to look for the maximum opportune moment to make a purchase.
The approach allows leveling the influence of market volatility. The strategy is ideal for passive investors, because they do not need to regularly monitor what state the market is in at the moment and do not need to wait for the most opportune moment to enter.
The strategy is used in different situations. First case: the investor has a large amount of money to deposit, but he is afraid to invest all the deferred amount he currently has. Second case: Some percentage of income is regularly invested. Let's take a closer look at each of the options.
Partial investment. Case one.
If you already own a lot of capital and want to invest in assets, then you will be faced with the intersection of two paths: invest all at once or in small parts. The second option is called the DCA strategy.
Let's say an investor has $5. He can both invest immediately, what he set aside for deposits, and invest, say, thousands of dollars within six months. During this period, assets will either increase in value or decrease.
In the first situation, when an investor decides not to invest in part, he can enter the market either at a low price or buy shares at too high a price. Because of this uncertainty, there is stress and great risks. The risks are related to the fact that having bought a certain asset for the “whole cutlet” and after a certain amount of time it costs less, the investor immediately turned out to be in the red when he actually planned to earn. It turns out that the wrong timing was simply chosen.
If the investor made purchases in several parts at different times, then in this case the assets are bought at an average cost, thereby guaranteeing smoother risks and a fair price for an asset-share.
Paradoxical as it may seem, research shows the following picture
As it turned out, it was more profitable to buy an asset with all the funds, and not to postpone-distribute investment for a long time. NB! The strategy is valid if you are willing to wait up to 10 years! The researchers analyzed the returns of all 10-year intervals from 1950 to 2021 and with an investment of one million dollars. For comparison, we took 2 methods:
- investment of all funds at once (LSI or Large Scale Investment);
- investment in parts (DCA or dollar-cost averaging - money was invested in equal portions over a certain period).
The two strategies were tested in three portfolios: XNUMX% US stocks, XNUMX% US bonds, and a combination of these asset classes. In almost all cases, the investment of all funds at once brought the investor a full return after ten years.
The main reason why the first strategy worked is because of the longer relationship between risk and return. It is known that investing in stocks carries a higher percentage of risk than investing in bonds. But bonds carry more risk than cash. But higher returns will be on assets with greater risk.
A portfolio that is dominated by more risky securities will bring more income to the investor in the long run. If an investor uses DCA, then he will stay in a cash position for a long time, which will not bring him income.
If you look at the statistics of most companies, then their stocks find new peaks more often than they fall. That is why the LSI strategy is often more effective and successful. During the study, tactics lost only in 10-24% of cases. And this happened in cases when, immediately after the purchase of an asset, a crisis occurred or bears prevailed in the market.
The DCA method is not particularly relevant if you plan to invest for a short period (within three to five years). If these are your plans, then it is advisable to shift your attention to low-volatility assets. The cost of such assets, although fluctuating, but not much, so you will achieve what you want - lower risks.
Regular deposits. Second case.
The DCA method is ideal for investing relatively small amounts. For example, an investor can regularly invest a certain part of the income in the stock market, which allows him to acquire the same asset every month.
An investor can replenish the portfolio not monthly, but create his own regularity. You can also send funds to safer instruments. In moments of strong drawdowns, on the contrary, you can accelerate or increase investments, thereby getting more benefit from constant investments.
STRATEGY BENEFITS
When using DCA, you can experiment with the frequency of deposits, rebalances, and other parameters. Of course, the DCA strategy has its advantages.
Peace of mind
It is important for investors to achieve emotional well-being, and not just fill the portfolio and measure its financial performance. The cost averaging strategy gives a sense of security and comfort, especially for beginners. The strategy allows you to teach the investor discipline and protect him from an unsuccessful choice of the investment time, as well as further negative situations when all portfolios are in red (minus). Constantly investing in small installments, regardless of what is happening in the market, will not cause much stress.
Also, the method protects against the likelihood of an investor making an ineffective decision due to poorly done analysis or external risks such as covid? The investor focuses on buying an asset for a specific amount and in a specific period, and market fluctuations do not bother him.
Ease
The strategy is perfect for all types of investors, especially those who do not want to actively participate in the analysis of markets or companies, since it does not take much time, and almost does not require participation. The investor will not monitor the market situation and conduct any analysis. In order to determine the necessary filling of the portfolio, its regular replenishment and additional purchase of assets that were previously selected are required. It is important to stick to your beliefs and occasionally check that everything is in order with the selected assets.
Benefit when the market falls
Often the strategy is used even by experienced investors in a bear market situation to gradually accumulate positions. If you wait for a drawdown, then you can completely miss the moment of a quick market recovery. Or, on the contrary, an investor can purchase assets with all his means before a correction occurs in the markets.
Many investors cannot, due to certain circumstances, constantly monitor the situation on the market. It is also important for many investors to feel calm. Under such circumstances, the DCA strategy is most appropriate.
Hack and predictor Aviator
DCA proposes to invest regularly the same amount for a certain period of time, regardless of what the asset prices will be. This will allow you to purchase an asset at an average cost. Investors who invest the entire amount of money at once buy assets only at the lowest or highest value.
The analysis data showed that investments in the stock market will be more profitable and pay off faster if done all at once. This also includes stocks and bonds. When delaying the moment of investment, the investor misses out on profitability. But it is worth recognizing that immediately investing a large amount is very risky. This risk affects the investor psychologically and causes constant stress, so for many, the cost averaging strategy is more relevant.
DCA - usually when using such a strategy, a small percentage of funds is invested from your main source of income or from an additional one. The option is ideal for inexperienced and investors who do not want to spend a lot of time managing their investment portfolio and monitoring the situation.