Investing Strategy: How does a Dollar Cost Averaging (DCA) strategy work?
A simplified example of a common investing strategy
I first published this in July 2023 on the Trading 212 app in the Value Investing community, under the username “Anathema”
Not strictly Value Investing, but I'm not sure where the best forum would be and thought it's not a bad fit here.
I've seen a few questions around Dollar Cost Averaging (DCA), so I thought I'd create a post that I hope makes it simple to understand. I will, of course, use some simplifications and assumptions. Here goes:
Imagine there is a stock that reliably matches the long-term performance of the stock market, assumed to be a consistent 7% rise every year. I am going to assume for simplicity that this stock does not pay a dividend, but i would get the same result if I assumed less of a capital gain per year, with the difference being used as a dividend, which I reinvested. I'm also going to assume the stock price rise happens at the end of the year rather than throughout the year for simplicity.
This theoretical stock has a stock price of £10 when I start investing, and I am going to invest £100 every month, which is £1200 invested per year.
Over the first year, I will have spent £1200 and by the end of the year, I will own 120 shares. By the end of the first year, the share price will have risen 7%, meaning a share now costs £10.70, and my 120 shares will be worth £1284. My average share purchase price is £10 and my return on my investment is 7%.
I continue to invest £100 a month. Over the next year, I can now only buy 112 shares, as each share is now more expensive than it was when I started investing. By the end of the second year, I will have invested £2400, I will own 232 shares in total, meaning my average share purchase price is £10.34. But my shares will now be worth £11.45 each, and my total investment will be worth £2,657, a return of 10.7%, which is a CAGR of 5.2% - this is obviously less than the market increase of 7% per year.
In my 3rd year of investing, my £100 per month will only let me buy 105 shares (rounding up), as each share now costs £11.45. I will now own 337 shares in total, having invested £3600 in total, an average share purchase price of £10.68. By the end of the year, each share will have increased in value to £12.25, so my 337 shares will be worth £4,128. This is a total return of 14.7%, a CAGR of 4.7%.
After 4 years, I will own 435 shares at an average share purchase price of £11.03. Each share will be worth £13.11, my investment will be worth £5,702, a return of 18.8%, a CAGR of 4.4%.
After 5 years, I will have almost 527 shares at an average purchase price of £11.40. Each share will now be worth £14.03, my investment will be worth £7,386, which is a return of 23% (CAGR = 4.2%).
Now, let's assume, instead of investing in a stock that consistently rises at 7% per year, I invest in a stock that rises 21% one year but drops 5.4% the following year. This stock also has a roughly 7% per annum average growth.
With this investment, I would achieve the following returns:
Yr 1: 120 shares, £1452 portfolio, 21% growth, £12.10 share price
Yr 2: 219 shares @ £10.95 avg, £2507 portfolio, 4.5% growth (2.2% CAGR), £11.45 share price
Yr 3: 322 shares @ £11.19 avg, £4458 portfolio, 23.8% growth (7.4% CAGR), £13.85 share price
Yr 4: 408 shares @ £11.76 avg, £5346 portfolio, 11.4% growth (2.7% CAGR), £13.10 share price.
Yr 5 (see N.B.): 500 shares @ £12 avg, £7009 portfolio, 17% (3.2% CAGR), £14.02 share price
(N.B. 7% growth assumed for Yr 5 for comparison to 1st example)
So you can see that, overall, I am constantly increasing my average share price and consequently my overall rate of return is tending lower, but I am continuously making a return. I am much less sensitive to peaks and troughs in the market. While the best returns can be achieved with a well-timed lump sum, DCA enables me to average through the good and the bad, achieving around half of the nominal share price growth over my investment period.
I hope this helps.