Dollar-Cost-Averaging
1.- Definition of Dollar-Cost-Averaging
Dollar-Cost-Averaging is an investment strategy thatconsists of entering the markets periodically and always with the same amounts of money, regardless of how the markets move. The Dollar-Cost-Averaging (translated into Spanish "average cost effect") allows us to benefit from fluctuations in the value of financial assets.
To understand Dollar-Cost-Averaging we will use an example. Suppose we invest €100 every month in an investment fund or in aETFsand we are going to obviate the transaction or purchase costs. Said fund or ETF is subject to oscillations in its value and let's imagine that these oscillations have a similar pattern to this in the next five months. The price of the fund or ETF will first rise, then fall below its initial level, and then return to the value from which we started five months earlier.
Let's then assume that the initial value of the fund or ETF is €50 for each share. This means that by investing €100 in the first month we will obtain two shares of the ETF. To better explain the "average cost effect", we are going to assume an extreme increase in the price in the following month up to €75. When we invest our €100 this month we no longer get two shares but only 1.33, since these are now more expensive. In the following month the price drops to its initial value of €50, so we can buy two shares again. In the fourth month, the price of the fund or ETF continues to drop to €25. For our €100 of the fourth month we will obtain four shares, since these are now cheaper. In the last month the price rises to the initial level of €50 and we obtain two shares for our €100.
Intuitively we would think that we have neither won nor lost anything, but we are going to see this calculation in more detail. In our stock account we now have 11.33 shares of the fund or ETF. If we multiply these 11.33 shares by the current market value, that is, the value of the fifth month, we see that the value of our securities account is €566.5. But our monthly contributions have been lower, since we have invested €100 5 times, that is, a total of €500. The difference, €66.5, is our profit due to Dollar-Cost-Averaging, which is equivalent to a return of 13.3%. Why is it then that we have earned money from price fluctuations? Let's look at the graph in more detail. In the second month our €100 only gave for 1.33 shares because the price had risen. However, in the fourth month, our €100 gave us enough to buy 4 shares, that is, twice as many as in the first and third months, because the price had dropped. It's like when we refuel at a gas station and we always pay the same. When the price of gasoline is cheap, more liters of gasoline enter our car, while when gasoline is expensive, fewer liters of gasoline enter us for the same money.
The example we have used is the typical example used by financial advisors trying to sell you their own smart investment plans. In this example, Dollar-Cost-Averaging works so well because we have used extreme values with a 50% up and down fluctuation. Let's calculate the same example but with a 10% move up and down, which is still a good move, but much more realistic.
This means the following: the initial value is still €50, so we can buy two shares in the first month. It goes up to €55 in the second month and we get 1.82 shares. In the third month it is worth €50 again and we obtain two shares for our €100. The fourth month we get 2.22 shares for our €100 since the price has dropped to €45. In the fifth month it goes up again to €50 and we get two quotes. In our securities account we now have 10.04 shares, which when multiplied by €500 per share we obtain €502.11. This means a profit of €2.11 with market fluctuations thanks to Dollar-Cost-Averaging and is equivalent to a return of 0.4%. Thus it is shown that the examples withextreme fluctuations best adorn the Dollar-Cost-Averaging.
The effect is called Dollar-Cost-Averaging or "average cost effect" because you buy at the average market price in that period and thus avoid the risk involved in timing. If you had invested the €500 in one go, you might have the bad luck to buy just at the moment when the price was at €75. On the other hand, you could also have good luck and invest when the price was €25. Since we cannot predict the evolution of the market in the short term, there is no way of knowing in advance when the best moment to invest will be. That is why it makes sense to minimize Timing risk and invest at average costs.
In this graph, the initial value is €100 and drops dramatically to €25. Later it recovers a bit but it never manages to trade above €75. If you had invested all the money at one time at the beginning, at the end of this period you would be with absolute certainty in losses. However, if you had invested €100 every month, then we would obtain one participation in the first month, 2 participations in the second month, 4 participations in the third month, 2 participations in the fourth month and 1.33 participations in the last month. In total we have 10.33 shares of that fund or ETF. Multiplying it by €75, the current price, it does not show that our securities account has a value of €774.75. However, we have only invested €100 in five consecutive months, that is, €500. The gains due to the Dollar-Cost-Averaging effect are €274.75.
2.- When does it make sense to use the Dollar-Cost-Averaging?
Obviously this last example is another extreme case, since in reality such large oscillations are not very common. But this example has served us to enter the second part of the article and illustrate that it makes more sense to use the Dollar-Cost-Averaging with high volatility financial assets. That is why it should be used withinvestment fundsofActions or stock ETFs.
On the contrary,it does not make sense to use the Dollar-Cost-Averaging in fixed-income investment funds or in real estate funds or with thebonds, since in this case there is a constant upward evolution with hardly any volatility that allows you to buy cheap in between. In these cases it is better to invest larger amounts at once and let the money grow with the evolution of the mentioned low volatility financial assets instead of buying in between at increasing prices.
In the three examples seen so far, the final price was equal to or below the initial price but never above it. But in the long term the market is rising. This is the main reason why we invest and on which the historical data is based.In rising markets it makes more sense to invest an amount at the beginning instead of using the Dollar-Cost-Averaging.
Let's see it with this example in which we invest €400 in the first month. After the fourth month, the value of the securities account is €560 (8 x €70), we would therefore have a profit of €160, which means a return of 40%. If we invest the €400 in four installments of €100, the value of the securities account is €483 (6.9 x €70). The profit in this case is 20.9% against 40% if you invested €400 at once at the beginning.
Logically, you can play with the numbers and look for examples in which the final price is higher than the initial price and the Dollar-Cost-Averaging exceeds a single investment. There are many economic studies, including Dr. Gerd Kommer's, which shows that in rising markets, a long-term investment is much more likely to outperform small term investments. This does not mean that the Dollar-Cost-Averaging is a very good tool in times of stock market crashes, that is, with a very high volatility as in the first examples of this article.
3.- Tips when using the Dollar-Cost-Averaging
What should be taken into account when using Dollar-Cost-Averaging?In addition to what we just mentioned about choosing an ETF or a stock fund with a certain volatility, it is equally important to take into account the costs,which we have purposely neglected so far to make the examples easier and more understandable. Many mutual fund management companies and custodian banks require high fees or transaction costs when making purchases on a monthly basis. Pay attention if you carry out an investment plan in ETFs or a savings plan and if you have the possibility, choose one that your depositary bank offers free of charge. And in investment funds, you must also pay attention not to pay more fees for investing monthly than if you invested in one go.
4.- Summary
In this article we have seen that the Dollar-Cost-Averaging or the "average cost effect" is an important concept that helps us save and invest regularly as well as helping us to benefit from the volatility of certain financial assets. In certain situations, such as a market crash or with volatile financial assets, it makes more sense to invest small amounts distributed over time instead of investing a larger amount at one time, thus reducing timing risk. With Timing risk we refer to the fact of investing just when the highest prices have been reached. Always pay attention to the costs that can arise from investing monthly, since for each transaction as well as for each purchase or sale, separate costs may appear.