The First Strategy that All Investors Should Learn
Do you feel lost when it comes to learning investment techniques?
There are too many investment strategies for one to apply. Which strategy should you learn first, second, or third?
In this blog post, I go through the first investment strategy that all investors should know before embarking on their investing journey.
Dollar Cost Averaging
What is Dollar Cost Averaging (DCA)?
DCA is an investment strategy in which an investor divides up the total amount to be invested across multiple periodic purchases of an asset in an effort to reduce the impact of price volatility (Investopedia, 2021).
By spacing out your purchase by a defined interval, you reduce the effect of purchasing at the wrong time.
As we all know, it is impossible to predict the future accurately and it is impossible to time your stock purchase at its lowest price. Thus, dollar cost averaging reduces the impact of a “bad” decision made during a “bad” time.
How often should you space it out?
It depends on which asset class you are looking at.
The rule of thumb is: the more volatile the asset is, the wider the time interval between each purchase and you will have to divide the purchase up into 10 times or more.
The less volatile the asset, the less periodic purchase you need and shorter time interval between it.
When should you use the DCA method?
The DCA method is extremely useful for any assets that fluctuate in value. If an asset’s value fluctuates a lot throughout a short period of time, you should use the DCA method.
If the asset doesn’t fluctuate in the short-term, the DCA method would not benefit much.
Real World Application
Ex: My trade is to purchase 3 Apple stock and I plan to space it out within 4 days. Every 2 days, I would purchase 1 Apple stock from the market. As Apple Inc is not a high-risk investment and it doesn’t fluctuate a lot in the short run, it is reasonable to space it out by only 2 days.
Breakdown:
Day 0 (now): Purchased 1 Apple stock at the price of $125
Day 2: Purchased 1 Apple stock at the price of $127
Day 4: Purchased 1 Apple stock at the price of $129
By dividing your purchase interval into three trades, the price of which you’ve purchased Apple stock is averaged out.
For those who want to understand the mathematic calculation, keep reading. For those who don’t and understood the concept, skip to the next section.
Mathematical Example
Day 0: Price Apple stock= $125
Day 2: Price Apple stock = $127
Day 4: Price Apple stock= $129
Average Price of Apple stock = (Day 1 Price + Day 2 Price + Day 3 Price) / (number of trades) = (125+127+129) / 3 = $127
Effectively, you’ve bought Apple stock for the price of $127. (this is known as your effective price).
Let’s say you didn’t use the DCA method, how would it have impacted you?
Let’s assume that Apple’s price is at $125 now and you expect it to go down in the next few days to $122. Unfortunately, your guess was wrong and Apple’s price is now rising exponentially.
You missed out on the opportunity to buy Apple’s stock at a low price. But you believe that it will continue to rise in the long term, so you bought Apple at $129.
The difference between you buying at $129 and your effective DCA price ($127) is about $2 per stock. That’s a big difference if you’re dealing with a larger quantity of Apple stock.
If you used the DCA method, you would profit $2 (per stock) more than the other person who didn’t use the DCA method.
The DCA method allows you to ignore the price volatility of an asset and allows you to buy the asset without worrying about timing.
Where can you apply the DCA method to?
The DCA method can be applied to the following asset classes:
Equities (ie: index funds, mutual funds, stocks, startup business, etc.)
Risk Level: Low to High (depending on the company you’re investing in).
Volatility: Medium
Commodities (ie: gold, silver, platinum, crude oil, wheat, corn, etc…)
Risk Level: Low to Medium
Volatility: Low / Medium
Cryptocurrencies (ie: Bitcoin, Ethereum, Dogecoin, Litecoin, Cardano, etc…)
Risk Level: High
Volatility: High
Foreign Exchange (ie. USD/HKD, USD/AUD, USD/CAD, USD/SGD, etc…)
Risk Level: Low to Medium
Volatility: Low
You can apply the DCA method to any of the asset classes mentioned above. If you’re not quite sure about what asset classes to invest in, you can always refer back to my previous “guides on investing.” Insert link
So far, I’ve covered the DCA method on how you could use it to purchase assets. You can also use the DCA method to sell your assets.
Using the DCA method to sell assets is exactly the same but you’re selling instead of buying.
The goal when selling your assets is to sell it at the best price. However, you never know when is the highest price you’re going to get before it goes down again.
Therefore, you sell your assets at multiple periodic purchases to reduce the price volatility impacts.
ONE EXCEPTION
If you’re certain that the asset you’re holding is declining at a rapid rate, you should immediately sell off your position.
You want to limit the loses and optimize your profits. Realize how I mentioned “optimize” not maximize. When you’re trying to maximize your profit, you will find yourself selling at a worse price.
Key Takeaways of this Blogpost:
Dollar Cost Averaging (DCA) is an investment strategy which an investor divides up the total amount to be invested across multiple periodic purchases of an asset in an effort to reduce the impact of price volatility (Investopedia, 2021).
The rule of thumb of when to use the DCA method is: if the asset is volatile use the DCA to reduce the short-term volatility impact. If not, the DCA does not benefit much.
Effective price is the average price of what you get from using the DCA method.
The DCA method can be applied to the following asset classes:
Equities (ie: index funds, mutual funds, stocks, startup business, etc.)
Risk Level: Low to High (depending on the company you’re investing in).
Volatility: Medium
Commodities (ie: gold, silver, platinum, crude oil, wheat, corn, etc…)
Risk Level: Low to Medium
Volatility: Low / Medium
Cryptocurrencies (ie: Bitcoin, Ethereum, Dogecoin, Litecoin, Cardano, etc…)
Risk Level: High
Volatility: High
Foreign Exchange (ie. USD/HKD, USD/AUD, USD/CAD, USD/SGD, etc…)
Risk Level: Low to Medium
Volatility: Low
You can use the DCA method to “sell” assets, but the exception is “if you’re certain that the asset you’re holding is declining at a rapid rate, you should immediately sell off your position.
Now that you know how to implement the DCA strategy, are you more confident at investing?
Try using the DCA method on your next trade and let me know how that goes in the comment section below or you can send me a DM on Instagram (@Leinvests_).
Looking forward to your response 😀