Jul 24, 20225 min read

What Is Dollar Cost Averaging?

Updated: Nov 19, 2022

DCA with a much improved performance!

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In this video we look at Dollar Cost Averaging and how you can build significant wealth over time.

My overall wealth building approach is a combination of a specific trading strategy and a form of dollar cost averaging. My Trading Strategy is applied when the market is bullish, and my Dollar Cost Average approach is applied to the major indexes after a considerable decline.

Let’s first look at how dollar cost averaging works.

The price of assets fluctuate over time, and the individual might make small frequent investments throughout its price cycle, instead of making one large initial investment, the process is very much like saving for retirement through a company pension, where the employee makes a frequent contribution.

Each of the contributions will have a different price depending on when each investment was made, but when combined, you can determine the average purchase price for the lifetime of your contributions, known as Dollar Cost Averaging. The goal is to keep the average dollar cost as low as possible.

There is a drawback of using dollar cost averaging, and that is when the method is used on singular stocks. Single stocks can continue to fall in value for years on end, whilst some never return. You may have reduced your cost basis by averaging into a position, but ultimately you could lose all your investment, which defeats the objective.

A recent example came from Jeremy over at the Financial Education channel, he kept on buying into a stock called Voyager Digital, hoping to average in at a lower cost basis each time, but eventually he lost everything when the stock went to zero and the company filed for bankruptcy.

The best or certainly the safest way to use dollar cost averaging, is through a well-diversified fund, like an index or ETF. If we take the S&P 500 for example, the index constantly tracks the largest 500 US stocks, the stocks that fall out of the top 500 are replaced each quarter with the next largest stock. This continual rotation ensures that you are only ever invested in the very best companies, hence why the index is so hard to beat and remains the benchmark for the financial industry.

The index is well diversified across all sectors, and we know from history that price has always recovered from any periods of drawdown, making this a great asset to apply the dollar cost averaging approach.

I use the approach on numerous indexes, but with a twist. I only average into each index after a significant decline, in almost all cases I look for at least a 25% decline from the previous high. This time we use the Russell 2000 index as an example, this index tracks 2000 of the smaller sized US companies which also makes it well diversified.

Recently we saw a drop of just over 25% from its peak price, I therefore made an investment at a price of 1837, a significant discount from the previous high. Using this approach throughout the price cycle of the index would have seen your investments entered at bargain prices, making the return on investment very favourable indeed.

In addition to the initial 25% drop, I make a further investment after each 10% decline from the previous entry point, during the pandemic for example I was able to make another investment after price dropped a further 10%, this made the position a very favourable risk reward proposition.

The other option would be to use a moving average or simply draw a trend line through prices to time your entry, perhaps adding positions only when price is below the line and ignoring positions above, this will keep your dollar cost average very low and your investment equity curve far more stable.

The current return from each of the previous investments can be seen here, and because each entry was at a low-risk point considering the 25% discount, it would not be unreasonable to suggest that a 2 to 1 leverage ratio could be used, thereby doubling the returns.

If we compare this to a more conventional dollar cost averaging approach and assume average price points, we can see that the returns could be considerably less. The key is lower price, lower risk, whilst allowing for the use of sensible leverage to enhance returns further. Just remember this should not be applied to singular stocks, only well diversified funds.

The principle of dollar cost averaging and leverage can also be applied across other asset classes, take property for example. This chart represents the UK property market and real prices once adjusted for inflation.

Property investors would have been wise to make their purchases when prices were below the trend line, often after a correction, whilst avoiding purchases above the trend. Similar to the previous example, we want a lower average purchase price, lower risk, enabling the use of leverage (in way of a mortgage) to enhance the return on investment.

Let’s switch back to the S&P 500 index to make another comparison. This study shows the performance of a $5000 lump sum investment in 2006, without any further contributions, this resulted in a closing balance of just over $10,000 10 years later. If however we started without a lump sum and made monthly contributions of $50 per month, the equity curve would have looked like this, reaching a similar end point but without the drawdown and psychological pain.

But again this study could have had a different outcome if the $5000 investment was made after a 25% correction, at a lower risk point, in which case the lump sum would have reached a similar end point of $10500, but with less drawdown and less time invested. In fact if the investment was made here you would have earned a 6.96% annualised return, whereas investing after the decline, the annualised return becomes 9.48%. It’s all about the timing and improving your dollar cost average. Not forgetting that the lower risk point would allow you to use a sensible 2 to 1 leverage, thereby increasing the annualised return to 18.96%.

Ultimately, you can take a passive approach and use Dollar Cost Averaging in its conventional form to get average returns, or you can be more active, look to get discounted prices at lower risk points, and combine with sensible leverage to enhance the returns considerably. Just be sure you apply the approach to a well-diversified Index or fund, whilst avoiding singular stocks.

In fact, Warren Buffet himself said:

“If you like spending six to eight hours per week working on investments, do it, If you don’t, then dollar-cost average into index funds.”

For those interested I found a great calculator which allows you to determine your own performance based on either a lump sum, monthly contribution, or a combination of both. The date goes all the way back to the 1800’s, whilst providing the annualised returns and equity curve. Be sure to check out the link below.

To really get your cash working for you, you can apply my Dollar Cost Averaging approach to the indexes at a discount, whilst also applying a singular stock breakout strategy when the indexes are showing momentum.

To learn more why not download my strategy or join our forum.

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