Investment, Insights | 30 May 2021
Delayed gratification is a strategy to reach your goals and finding long term fulfilment. While instant gratification happens when one leads to short-term benefits that feel great for the moment but goes off quickly.
In the world of investing, the most seen and/or commonly heard sentence will be…. It depends. However, most importantly, the question should be is “What is next?”
Today, let us visit how Delayed gratification can help investors in their portfolio management. One of the Delayed gratification strategy is Dollar-Cost Averaging.
What is Dollar-Cost Averaging?
Dollar Cost Averaging is simply a strategy by putting a fixed amount of money over a period into a particular investment at regular intervals, typically monthly or quarterly, regardless of the price fluctuations.
Why?
Over a period, this strategy will be able to capitalise on market cycles and to mitigate timing risk, by purchasing more units when prices are low and fewer units when prices are high.
First, Dollar-Cost Averaging “smooths” out the buy price over time and ensure that money is not dumped all in to buy at a high price. Thus, it reduces the impact of market volatility by spreading out the buy price over time.
Second, by buying at regular intervals and in roughly equal amounts. When done properly, it can have significant benefits for your portfolio.
Third, Dollar-Cost Averaging can be extremely powerful in a bear market, it allows you to “buy the dips,” or buy at low points when most are afraid to buy. Committing to this means you will be investing when market is down, and that in when investors score the best deals.
Fourth, it removes emotional fear, as the ability to manage one’s emotions when making rational decisions is a key trait of successful investors. However, this is easier said than done, which is why many investors with a long-term view use dollar cost averaging strategy to help them manage risk and remove emotions from the equation.
Fifth, although in timing the market accurately, an investor would reap potential higher returns. However, not many investors are able to do so on a consistent basis. Dollar-Cost Averaging avoids mistiming the market
Any Drawbacks of Dollar-Cost Averaging?
Three common downsides of Dollar-Cost Averaging are modest.
First, buying more frequently adds up to costs. However, with fees and charges ever less to invest, this expense becomes more manageable. Moreover, if you are investing longer-term, fees should become exceedingly small relative to your overall portfolio. Remember you are buying for the long haul, not trading in and out of the market.
Second, by adopting Dollar-Cost Averaging, you may forgo gains that you otherwise would have earned if you had invested in a lump-sum purchase and the investment rises. However, the success of that large purchase relies on timing the market correctly, and most investors are notoriously terrible at predicting short-term movement of a stock or the market. If an investment does move lower in the near term, dollar-cost averaging means you should come out way ahead of a lump-sum purchase if the stock moves back up.
Third, Dollar-Cost Averaging strategy is not a substitute for identifying good investments. It is not a solution for all investment risks. Research and identifying good investments must be done even if you opt for a passive Dollar-Cost Averaging approach. If the investment you identify turns out to be a bad pick, you will only be investing steadily into a losing investment. Also, by adopting a passive approach, you will not be responding to the ever-changing investment environment.
How is Dollar-Cost Averaging Works?
To understand how Dollar-Cost Averaging can benefit you, you need to compare it to other possible buying strategies, such as purchasing all your shares in one lump-sum transaction. Below are a few scenarios that illustrate how dollar-cost averaging works.
Scenario 1: Lump-sum purchase
First, let us see what happens with a $10,000 lump-sum purchase of unit trust at $50, netting 200 units. Let us assume the price reaches the following prices when you want to sell. The column on the right shows the gross profit or loss on each trade.
| Sell Price | Profit or Loss |
| $40 | -$2000 |
| $60 | $2000 |
| $80 | $6000 |
This is the baseline scenario. Now let us compare it with others to see how Dollar-Cost Averaging works.
Scenario 2: In a Falling Market
Here is where dollar-cost averaging really shines. Let us assume that $10,000 is split equally among 4 purchases at prices of $50, $40, $30 and $25 over the course of a year. Those four $2,500 purchases will buy 295.8 units, a substantial increase over the lump-sum purchase. Let us look at the profit at those same sell prices again.
| Sell Price | Profit or Loss |
| $40 | -$1832 |
| $60 | $7748 |
| $80 | $13664 |
With dollar-cost averaging, you bought more units when the price drops, below where you first started buying the unit trust. Because you own more units than in a lump-sum purchase, your investment grows more quickly as the price goes up, with your total profit at an $80 sale price more than doubled.
Scenario 3: In a Flat Market
Here’s how Dollar-Cost Averaging performs in a market that is going mostly sideways, with a few ups and downs. Let us assume that $10,000 is split equally among 4 purchases at prices of $50, $40, $60 and $55 over the course of a year. Those four purchases will get 199.6 units, basically what a lump-sum purchase would get. So, the payoff profile looks nearly identical to Scenario 1, and you are not much better or worse off.
This scenario looks equivalent to the lump-sum purchase, but it really is not, because you have eliminated the risk of mistiming the market at minimal cost. Markets can often move sideways — up and down but ending where they began — for long periods. However, you will never be able to consistently predict where the market is heading.
In this example, the investor takes advantage of lower prices when they are available by Dollar-Cost Averaging, even if that means paying higher costs later. If the price had moved even lower, instead of higher, Dollar-Cost Averaging would have allowed an even larger profit. Buying the dips is tremendously important to securing stronger long-term returns.
Scenario 4: In a Rising Market
In this final scenario, let us assume the same $10,000 is split into four instalments at prices of $50, $65, $70, and $80, as the market rises. These purchases would net you 155.4 shares. Here is the payoff profile.
| Sell Price | Profit or Loss |
| $40 | -$3782 |
| $60 | -$676 |
| $80 | $2432 |
This is the one scenario where Dollar-Cost Averaging appears weak, at least in the short term. The stock moves higher and then keeps moving higher, so Dollar-Cost Averaging keeps you from maximizing your gains, relative to a lump-sum purchase.
But unless you are trying to turn a short-term profit, this is a scenario that rarely plays out in real life. Markets are volatile. Even great long-term investment instruments move down sometimes, and you could begin Dollar-Cost Averaging at these new lower prices and take advantage of that dip. So, if you are investing for the long term, do not be afraid to spread out your purchases, even if that means you pay more at certain points down the road.
Does Dollar-Cost Averaging really work?
It is easy to imagine scenarios in which a lump-sum purchase beats dollar-cost averaging. But in general, dollar-cost averaging provides three key benefits that can result in better returns. It can help you:
- Avoid mistiming the market
- Take emotion out of investing
- Think longer-term
In other words, dollar-cost averaging saves investors from their psychological biases. Because investors swing between fear and greed, they are prone to making emotional trading decisions as the market gyrates.
However, if you are dollar-cost averaging, you will be buying when people are selling fearfully, scoring a nice price and setting yourself up for strong long-term gains. The market tends to go up over time, and dollar-cost averaging can help you recognize that a bear market is a great long-term opportunity, rather than a threat.
What is next?
There are several alternative strategies to Dollar-Cost Averaging, each their pros and cons. Although they can require a more hands on approach. So do remember to choose a strategy that balances the risk with your expectations
One good question that I always ask myself is assuming I buy a lump sum $10,000 investment for a duration of one year, and it gains 100% (which it usually will not) and now I have $10,000 (capital) + $10,000 (profit). Can I consistently do the same? What is my goal and objective? What am I going to do for my next investment? Some food for thoughts till my next sharing…
External Links:
Dollar-Cost Averaging (DCA)
What is Dollar-Cost Averaging and When to Use It?.
What is Dollar-Cost Averaging?
Dollar-Cost Averaging: Definitions, Examples and the Pros and Cons for Singapore Investments