February 28, 2021

Averaging into Positions

Averaging into Positions

Timing the market is hard, maybe even impossible. This may be a given for many seasoned investors, but for many starting out, the urge to "buy low and sell high" is accompanied by larger lump sum transactions, leading to suboptimal returns. This is especially true in volatile market environments like seen in 2020 with the COVID-19 pandemic.

So how do you get around this?

This is where Dollar Cost Averaging (DCA) comes in. The idea is to slowly gain exposure to positions, getting small amounts of a position at a time as opposed to making one big investment.

Example

For this example, we will assume the following:

  • You have $1,000 to invest
  • You want to invest in company ABC that is currently trading a $100 a share
  • ABC's price changes one per month
  • The initial investment occurs during Month 1
  • For this fictional 12 month period, here are ABC's share prices:
    • Month 1: $100
    • Month 2: $80
    • Month 3: $120
    • Month 4: $90
    • Month 5: $70
    • Month 6: $60
    • Month 7: $50
    • Month 8: $70
    • Month 9: $80
    • Month 10: $70
    • Month 11: $90
    • Month 12: $100

Lump Sum Investment

If you were to invest your entire $1,000 month 1, you would be able to purchase 10 shares of company ABC. At the end of month 12, the closing price of ABC was $100, so your investment would be worth $1,000, a whopping 0% return on investment ?.

DCA

This is where the real fun begins. Instead of making a one time $1000 purchase, the idea is to spread out the $1000 over all 12 months, by purchasing 1 share a month.

  • Month 1: Purchase 1 share for $100
    • Share Price: $100
    • Shares Owned: 1
    • Average Cost Per Share: $100
    • Investment Value: $100
    • Cash Balance Remaining : $900
  • Month 2: Puchase 1 share for $80
    • Share Price: $80
    • Shares Owned: 2
    • Average Cost Per Share: $90
    • Investment Value: $160
    • Cash Balance Remaining : $820
  • Month 3: Purchase 1 share for $120
    • Share Price: $100
    • Shares Owned: 3
    • Average Cost Per Share: $93.33
    • Investment Value: $300
    • Cash Balance Remaining : $720
  • Month 4: Purchase 1 share for $90
    • Share Price: $90
    • Shares Owned: 4
    • Average Cost Per Share: $92.50
    • Investment Value: $360
    • Cash Balance Remaining : $630
  • Month 5: Purchase 1 share for $70
    • Share Price: $70
    • Shares Owned: 5
    • Average Cost Per Share: $90.00
    • Investment Value: $350
    • Cash Balance Remaining : $560
  • Month 6: Purchase 1 share for $60
    • Share Price: $60
    • Shares Owned: 7
    • Average Cost Per Share: $86.67
    • Investment Value: $420
    • Cash Balance Remaining : $500
  • Month 7: Purchase 1 share for $50
    • Share Price: $50
    • Shares Owned: 7
    • Average Cost Per Share: $81.43
    • Investment Value: $350
    • Cash Balance Remaining : $450
  • Month 8: Purchase 1 share for $70
    • Share Price: $70
    • Shares Owned: 8
    • Average Cost Per Share: $80.00
    • Investment Value: $560
    • Cash Balance Remaining : $370
  • Month 9: Purchase 1 share for $80
    • Share Price: $80
    • Shares Owned: 9
    • Average Cost Per Share: $80.00
    • Investment Value: $720
    • Cash Balance Remaining : $290
  • Month 10: Purchase 1 share for $70
    • Share Price: $70
    • Shares Owned: 10
    • Average Cost Per Share: $79.00
    • Investment Value: $700
    • Cash Balance Remaining : $220
  • Month 11: Purchase 1 share for $90
    • Share Price: $90
    • Shares Owned: 11
    • Average Cost Per Share: $80.00
    • Investment Value: $1089
    • Cash Balance Remaining : $140
  • Month 12: Purchase 1 share for $100
    • Share Price: $100
    • Shares Owned: 12
    • Average Cost Per Share: $74.16
    • Investment Value: $1200
    • Cash Balance Remaining : $40

Tallying the Results

  • Lump Sum
    • Starting Value: $1000
    • Ending Value: $1000
    • Total Return Return: 0%
  • Dollar Cost Averaging (DCA)
    • Starting Value: 1000
    • Ending Value: 1240
    • Total Return: 24% ?

Tips and Takeaways

  • Why the above example is rather simple, it clearly illustrates how dollar cost averaging can lead to higher potential returns over time while limiting the overall effect from market price fluctuations, regardless of direction.
  • Consider automating the purchasing of positions at a given interval to take advantage of DCA with minimal management overhead and to reduce the emotional component of investing.
  • As with any investment, it is important to identify good investments use with dollar cost averaging.
  • This a "boring and simple" method that is great for less experienced investors in addition to those who do not actively manage their portfolios.

Feel free to leave any questions in the comments below.

Happy Trading!

Disclaimer