Some of you may be familiar with this (the Meme and the concept)..
Markets are “technically” an objective representation of value, of which is mostly subjective.
And because of this subjectivity, objective valuation can become distorted — especially during times of heightened emotion.
When things are going up, people get exuberant and they keep bidding prices higher & higher.
When things are going down, people get scared and often run for the exits causing prices (and thus the perception of value) to go out the window.
Markets by their very nature, are a representation of mass human emotion, ie; Fear & Greed and when you can understand that better, you can develop models to overcome the emotional swings that inevitably come with trading or investing.
One such model is: “Dollar Cost Averaging”.
What is Dollar-Cost Averaging?
Dollar-Cost Averaging is simply investing a fixed amount of money at regular intervals for a certain time period, regardless of the asset price at the time.
It’s a set & forget strategy, which makes it easy.
Over the last 100yrs studies have shown that it’s has been one of the most effective strategies for long term investment returns and in most cases, this is irrespective of the asset class!
The idea behind this strategy is to spread your investments out to achieve a lower average cost base, which means you purchase a greater number of units for the same investment amount.
Markets will always fluctuate and instead of attempting to “time the market” (which probably less than 0.0001% of the population can realistically do), you just buy at set intervals, un-emotionally and irrespective of the current sentiment.
Dollar Cost Averaging helps to avoid situations like THIS:
After the Bitcoin Boom: Hard Lessons for Cryptocurrency Investors
Tony Yoo, a financial analyst in Los Angeles, invested more than $100,000 of his savings last fall. At their lowest point, his holdings dropped almost 70 percent in value.
Most people’s experience.
Trading is hard. It’s one of the most un-emotional / robotic professions in the world, and most people are just not wired for it.
Dollar cost averaging is a great way to, remove the emotion, smooth out the volatility, alleviate the stress and;
If your long term views are accurate, earn a great return.
If your long term views are wrong, minimise the loss.
To understand exactly how it works, here’s a case study:
Case Study in Action
Let’s say you receive $10,000 from your grandma and you want to invest it into something with some high return potential, that’s also a little volatile.
Let’s use Tesla. Elon’s company. Great poential, lots of volatilty at the moment. TSLA: NYSE?
You can choose to either:
Invest the entire $10,000 now, or by attempting to pick the “best” price
Invest it equi-proportionately ($1000 every month) over a period of 10 months until it is fully utilised.
The first method demonstrates lump-sum investing whereas the latter method demonstrates dollar-cost averaging.
Most people would have invested at the first sight ot the price “running up”. So let’s assume that the investment journey started at the beginning of June.
Tesla (TSL) Shares over the last 14mths
Scenario #1: Lump Sum
In this scenario, you would have:
Invested $9,940 at $355 per share.
That equates to 28 TSLA shares
Today, the value of your position would be about: $9016
That’s about 10% lower than when you started.
That’s not a great result although not the worst thing we’ve seen, especially considering recent volatility in the markets.
10% difference, from then until now.
The hardest part for most people would’ve been sitting through the lows.
At some points, that $10,000 would’ve been worth around $8000, and more recently as low as $6500.
Scenario #2: Dollar Cost Averaging
In this scenario, you would have invested your $10,000 over 10 months, at roughly $1000/mth.
If you take a look at the graph below:
Month 1: the share price is $355;
Month 2: $305,
Month 3: $355,
Month 9: $340,
Month 10: $322