Dollar-cost averaging (DCA) has been a really hot topic at the moment in most forums and social media platforms. The reason behind it is because many people are thinking of buying more shares to average down their holdings. While understanding the logic behind DCA is simple, many do not realize that DCA is actually very expensive to do. Besides paying commissions, which is less significant when you are buying large enough tranches, DCA will also increase your losses as you accumulate. Though DCA technically allows you to buy at an increasingly cheaper price per tranche, it will inevitably increase your capital risk as the downtrend continues. In this post, I hope I can capture all vital information of DCA so that you can have a clearer understanding of the potential risks and paper losses before it actually happens.
After taking some time to digest the table above, you would have realized that by averaging down, the cost of DCA actually decreases as the share price continues to fall. This is actually one of the few benefits of accumulation during a downturn. The lower cost of accumulation warrants higher returns eventually when the upturn begins. Besides that you would have noticed that by the 9th order, the accumulated paper losses would have surpassed the value of the first tranche purchase, this means that you have lost more than 100% of your first order’s capital. However, not to worry as the total vested capital has also increased significantly.
During the downtrend, DCA helps to regulate or slow down the drop in portfolio value. After purchasing 9 tranches the unrealized paper losses is -15.38%, however, factoring only Tranche number 1, the unrealized paper losses are -26.6% by itself. This shows that with each subsequent tranche purchase, your portfolio paper losses will be lessened.
That said with each tranche purchase, the absolute paper losses will also increase at an increasing rate. The red curve above shows the increasing decline in portfolio value. That said, DCA does help to slow down the decline in percentage loss of your portfolio.
Even though DCA is carried out after every decline of 10 cents in the above example, the average share price deviates from the subsequent entry price as shown in the chart above. This means that there are diminishing returns with DCA and you might consider increasing the volume of each tranche if you are comfortable taking additional capital risks.
Suggested DCA Strategy
Even though DCA is able to slow down the decrease in portfolio value (in percentage), it does not prevent increasing absolute paper losses. Furthermore, the law of diminishing returns applies to DCA as well, hence there is a need to spread out your purchases with a substantial price difference to enhance the benefits of DCA. Last but not least, DCA is an expensive strategy for the short term, Do not engage in DCA strategy unless your time horizon is long enough to tide past the downtrend.
Closing thoughts
Before considering to use any strategy, It is also important to anticipate the potential outcomes of the strategy. As the downtrend might extend far beyond the limit of your DCA strategy, you might want to set aside contingency funds in your strategy from the beginning to lessen capital risk. All in all, the DCA strategy helps to take advantage of downturns and stock discounts while accumulating but there are no guarantees that the market will cooperate flawlessly. My best suggestion to everyone is to stay disciplined to your planned strategies but always expect the market to react in an unexpected manner. This is because you should always rather earn less than lose more.
