Dollar Cost Averaging is an investment plan which requires the same amount of money to be invested in the same stocks or mutual funds at regular intervals. This strategy aims at neutralizing the impact of volatility in the equity market in the long run. The advantage of this strategy is that it allows new investors to invest with a relatively small amount. The investor decides about the fixed amount of money invested at regular intervals and the time period for which the investments are made.
How Dollar Cost Averaging works?
In Dollar Cost Averaging, an investor is supposed to invest a specified amount of money in the same mutual fund or stocks at the regular intervals consistently. Whether the price of the stock is high or low, the investor will put the same amount of money into it. Depending on the price of the share at the time of the purchase, the number of shares purchased in each month will differ. If the price of the share goes up, the investor will get fewer shares. On the other hand, if the price of the share goes down, the investor will get more shares in the same amount invested. When investors buy more shares at a low cost, the average cost per share reduces over time.
Real World Examples of Dollar-Cost Averaging
A perfect example of dollar cost averaging is a 401(k) plan. It is one of the most popular retirement plans in America. This plan allows an employee to choose between taking compensation in cash or putting off a percentage of it to a 401(k) account under the plan. The deferred amount is usually non-taxable until it is taken out or distributed from the plan. Before taking out taxes, employees are able to invest a part of their salary.
In another example, suppose an investor deposits 50,000 INR on the first of each month into Mutual Fund X, starting from April. Every month, the price of this fund fluctuates. Per share price of the mutual fund for 5 consecutive months is as follows.
April- Rs 1000 per share
May- Rs 800 per share
June- Rs 600 per share
July- Rs 850 per share
August- Rs 1150 per share
The investor keeps investing Rs 50,000 into the fund at the beginning of each month consistently. The number of shares that amount of money can buy is as follows.
At the end of five months, the investor has 298.08 shares of the mutual fund X. The investment of Rs 2,50,000 will yield a profit of Rs 92,792. The average price of those shares is Rs 838.70. The investment of Rs 2,50,000 has turned into Rs 3,42,792 based on the current price of the shares.
Here, staggering of the purchases has greatly reduced the risk of the investment.
Mistakes to avoid with Dollar Cost Averaging
Inconsistency in investing
One must invest the same amount or percentage each time on a regular basis in order to avoid saving at different ratios. This will lead to the elimination of the purpose of dollar cost averaging which is smoothening out the effects of the market’s volatility.
Taking the break from investing at the worst possible time.
Sometimes, an investor might think of taking a break in dollar cost averaging. This will lead the investor to time the market and chase returns. Besides, when an investor stops a dollar cost averaging plan, he would miss a portion of returns.
If the price of a stock is falling too down, then the investor should sell it and dollar cost averaging should be stopped at that time. The investor should set a limit on the price falling of the stocks. If it goes beyond that, the investor should put dollar cost averaging on an emergency brake.
Ignoring transaction fees and trading costs.
Dollar cost averaging requires buying into the market regularly which incurs trading costs. If not paid attention, this can add up and can vary drastically by the brokerage.
Dollar cost averaging is a tool of the investors which will help to build wealth over a long period. It is a long-term strategy irrespective of the amount you invest. This strategy will definitely offer good or better results when followed by rules.