How Dollar Cost Averaging Works
Want to watch the post instead of read it? Check it out here: https://youtu.be/bh2b5VbfhK0
I’m going to introduce you to a concept that will help take some of the decision making out of stock trading.
Maybe you think, well I want to buy some Apple stock, or I want to invest in Tesla. But when do I do it? Should I do it now while the stock is at its highest point, or should I wait? And if I wait, will it go down or go further up? How do I decide?
The concept? Dollar cost averaging (DCA).
Dollar cost averaging is a buying strategy that lessens the volatility of stock purchasing by spreading the purchase over a longer period so that as the stock goes up and down, you are buying in at different points.
It’s especially helpful when you are adding risky or volatile individual stocks to your portfolio.
It works like this—if you wanted to own $10,000 of Amazon stock, instead of buying $10,000 today, you buy $2,000 this month, $2,000 next month, $2,000 the month after that and so on until, after five months, you own your $10,000.
So what’s the advantage? It lowers your overall risk.
Let’s play with a scenario to demonstrate this:
Say you bought your $10,000 of Amazon stock today while the price is hovering around $3,389.
Now, over the month, the stock drops 10%. Yikes—you lost $1,000. That hurts. Especially when you consider that it has to go up MORE than 10% to get your money back. Think about it--$10,000 becomes $9,000 when it loses 10%. But if $9000 GAINS 10%, it is only $9,900—you’re still out $100. It’s rough to lose money
Okay, but you are using buy and hold, so the next month the stock goes up 5% so you’re sitting at $9,450.
The third month, the stock goes up 8%, so now you’ve got $10,206. You’re feeling good because now you’re ahead of your investment.
Of course, right when you start feeling good, the stock drops 6% for the fourth month, leaving you at $9,593.
In it’s last month, it goes up 5%, which takes you to $10,073. A wild roller coaster ride that ended with you up $73.
Now look at the scenario using dollar cost averaging:
You buy $2,000 of the stock. The stock drops 10% this month leaving you at $1,800. You buy another $2,000 of the stock.
The stock goes up 5% so you now have $3,990 total. You buy another $2,000 of the stock and then watch as it goes up 8% bringing you to $6,469.
You buy again, at $2,000, and then the drop of 6% which takes you to $7,961. Your final buy in of $2,000 happens and, in the final month, a climb of 5% which finds you, after all is said and done, with $10,558.
Compare that $558 return with the $72 return and you can see how, at times, dollar cost averaging can work out for the best. Another benefit is that fact that, because you are buying over time, you are less likely to be glued to the computer screen living every moment in a state of stress while waiting for the stock to go up. You are more free to live your life.
Also keep in mind that it doesn’t always work out this way. If the stock shoots up the first month, you miss out on some gains, but you temper that with the fact that you have lessened your overall volatility with the stock.
In all, dollar cost averaging is a fine strategy to add to your financial toolbox as you build your wealth and grow your portfolio.
For more tips like this, check out the online classes from The Seed Tree Group (including our full-length class for young adults between age 14 and 22).