Dollar Cost Averaging In Action
Not that you asked, but it is a time saver and a money maker.
As with Dividend Reinvestment In Action, this article showcases actual transactions using the dollar cost averaging method of investing.
Dollar Cost Averaging is buying the same asset at a set investment price at regular intervals.
- Buying bitcoin with $200 on a biweekly basis is an example of Dollar Cost Averaging (DCA).
- Buying bitcoin with $200 this week, $100 four weeks from now, and $50 two weeks later, is not DCA. The investments are irregular in time and value.
Why DCA?
DCA is common through automated investment plans, such as a 401ks and IRAs. In those saving vehicles, it is typical to choose stocks, ETFs, or mutual funds to direct new investments to. This prevents you from having to make the investment decision every paycheck.
The important decision is made upfront: what do I invest in?
And implicitly the question of at what price will I pay for it is answered. You will pay the price on the day the automated transaction happens.
DCA is not limited to payroll deductions to retirement accounts. Many trading platforms have mechanisms for establishing automated transactions in cryptos, stocks, ETS, mutual funds. Retirement accounts, though, are likely the first exposure for many people starting out in investing.
What Does DCA Look Like?
It can be an eyesore, that is for certain.
This table shows the last 40 transactions of investing $200 into the Vanguard Total Intl Stock Index Trust every two weeks at various prices per unit. The date range is chosen to showcase swings in prices brought on by COVID-19.
This is what DCA looks like.
When the price is low, more units are purchased; when the price is high, fewer shares are purchased.
Dollar Cost Averaging takes away any decision making on is this a good price. It helps avoid trying to time the market. It is mostly set-it-and-forget-it investing (periodically checking in to ensure the investment is still meeting your needs is a good practice). DCA can help reduce emotional investing.
From the low to the high is more than a 80% swing. DCA takes away guessing when to buy or sell, and you keep buying until you decide to change course.
Average Cost Per Share
DCA is also referred to as constant dollar plan, which could be a more sensical name: there is a plan to invest a constant amount of dollars.
The Cost Averaging of Dollar Cost Averaging comes from the math.
Totaling up the 40 values for Price Per Unit comes to $4,306.81. Dividing that by 40 installments equals $107.67. This suggests that the average price per unit is $107.67. That is not correct.
Consider three cartons of eggs.
Adding the last column ($1.31) divided by three values is equal to $0.44. This appears to be the average cost per egg.
The actual average is the toal Cost ($14.97) divided by the total eggs (36).
Total price paid is $14.97 ÷ 36 eggs purchased is $0.416 per.
Not a huge difference.
From the transaction table above:
$8000 paid ÷ 76.006 units bought = $105.255 per unit.
The dollar cost average price is $105.255 per unit, again, not a huge difference in this example, but other real life scenarios could have larger differences.
Ultimately this tells you if you sell for more than $105.255 then there is an overall profit, and selling below, there is a loss.
Calculating Returns
Calculating the returns is more involved than using the Compound Annual Growth Rate. Not just more involved, but more methods.
Simple Dietz. Modified Dietz. Time-weighted Return Rate. Money-weighted Return Rate.
Each has benefits and downsides.
Your brokerage account might provide a Personal Rate of Return, and it could be for the entire account and not individual investments. The brokerage will likely use one of the methods noted above.
For index or mutual funds in a retirement account, such as the example used, the Simple Dietz calculation is a good start. It is reasonable because the inflows are identical at the same intervals ($200 every two weeks in this scenario).
I will not show other calculation methods, but googling any of them will yield some explanations and examples.
Simple Dietz
This assumes that all additional funds and all withdrawals are spread evenly compared to the middle of the investment period:
In the example of 80 weeks, the mid point is October 9th (between the October 2nd and the October 16th purchases). The calculation is:
Rate = (Ending Value minus Beginning Value minus Net Flows) ÷ (Beginning Market Value plus (Net Flows ÷ 2)
From the data provided
- Rate = (9,776.65 minus 200 minus 8000) ÷ (200 plus (8000 ÷ 2))
- Rate = (1.576.65) ÷ (4200)
- Rate = 37%
That’s not to say each $200 invested has returned 37%, some have lost value, but overall, that’s the Personal Rate of Return using the Simple Dietz method.
Wrap-Up
Dollar Cost Averaging is used when an investor has available funds regularly for investing, such as each pay period. Once an investment is determined, purchases happen at regular intervals. There is no timing of the market or additional work needed.
It saves you time by taking all of the guess work of what to buy and when and moves that to a single upfront decision with periodic check-ins.
The rate of return is ideally provided by the brokerage account. It is calculable outside of that using various methods, depending on how deep you want to get into learning it.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
