Understanding Dollar-Cost Averaging Strategy

What is Dollar-Cost Averaging Strategy?

Every investor desires to buy the dip and park a lump sum in a particular stock. But you may not be able to time the market due to some constraints. Even if you are able to do it, there are chances that you may go wrong. Here is when the Dollar-Cost Averaging Strategy comes in handy. It negates the need to time the market and allows you to deal with market volatility without dedicating much time to tracking markets.

Dollar-Cost Averaging Strategy is a Systematic Investment Plan that demands an investor to invest a certain amount at regular intervals. The frequency of the investment is subjective and depends on the investor’s source of income. You simply buy the asset irrespective of its price fluctuation.

Now that we’ve understood what is Dollar-Cost Averaging strategy, let’s look at an example to understand it better.

Mohan is a salaried person who has decided to invest ₹1000 every month in the Nifty Index Fund out of his salary irrespective of the market being positive or negative. The calculations will be as follows-

Here at the end of the 5th month, Mohan was able to buy 75 units of the index fund because he used the Dollar-Cost Averaging investment plan. If he would’ve invested a lumpsum of ₹5000 in the 1st month, he would’ve gotten only 50 units. But by following the Dollar-Cost Averaging strategy, he is able to buy 75 units!

Another example would be

Let’s say Kashi decides to invest Rs. 100 every month in ABC stock. The stock’s price in the first month is Rs. 50 per share, so Kashi buys two shares. The stock price drops to Rs. 25 per share in the second month, so she buys four shares. In the third month, the stock price rises to  Rupees 75 per share, so she can only purchase one share.

Over the course of these three months, she has purchased a total of seven shares for Rupees 300, resulting in an average purchase price of  Rupees 42.86 per share (Rs 300/7 shares). This average purchase price is less than the average of the stock’s price over the three months, which was Rs. 50 (Rs. 50 +  Rs. 25 + Rs. 75/3 = Rs. 50). By using the Dollar-Cost Averaging strategy, the investor was able to purchase more shares when the price was low and fewer shares when the price was high, resulting in a lower average purchase price.

Limitations of Dollar-Cost Averaging Strategy

Dollar-Cost averaging is a popular investment strategy that involves investing a fixed amount of money at regular intervals over a long period. While this approach can provide several benefits, there are also some limitations to consider, including:

1. Market timing risk:

   Dollar-Cost Averaging assumes that the market will rise over time, but this is not always the case. If the market declines significantly during the investment period, the returns may be lower than expected.

2. Opportunity cost:

   By investing a fixed amount of money at regular intervals, investors may miss out on opportunities to invest in undervalued assets.

3. Transaction costs:

   Frequent transactions can increase costs due to commissions, fees, and taxes, which can eat into the returns.

4. Emotional stress:

   The regular investments required by Dollar-Cost Averaging can be emotionally stressful for some investors, especially during times of market volatility.

5. Market inefficiency:

   Some studies suggest that Dollar-Cost Averaging may not be as effective in efficient markets, where prices quickly incorporate new information.

6. Low returns:

   In some cases, dollar cost averaging may result in lower returns compared to investing a lump sum, especially if the market experiences strong gains during the investment period.

Overall, while Dollar-Cost Averaging can be a useful investment strategy, it is important to consider these limitations and to weigh the potential benefits against the risks and costs involved.

Final words

Now that you have understood the Dollar-Cost Averaging Strategy, open a Demat Account with Angel One and start your investment journey.