The Downside of Dollar-Cost Averaging

Credit: hobvias sudoneighm

Ever wondered when a good time to buy a stock is?

This can be a difficult question to answer due to the short-term volatility of stocks. One strategy that has emerged over the years to attempt to solve this problem is dollar-cost averaging.

This strategy involves buying smaller amounts of stock multiple times over a period, instead of just buying all at once. This reduces the risk of buying all your shares at the peak of the market.

For example, Mr Lim, who is looking to buy $10,000 worth of Company X, can decide instead to buy $5000 worth of Company X today and another $5000 worth in three months’ time. Mr Lim does not make his investment decision based on the particular price of the stock at that time. But instead, he is committed to purchasing the dollar amount of stock after a specified period.

In theory, this can minimise the effects of short-term volatility of a stock on your investments as you can average out the purchasing price that you fork out.

But does it pay off in the long-term?

Difference in commissions cost

Many brokerages in Singapore charge a minimum brokerage fee regardless of the value of your stock purchase. Because of this, dollar-cost averaging may, in fact, lead to additional cost to the investor.

Take the example below.

The first scenario is an investor who decides to buy the company out right with his allocated $10,000 capital. The brokerage he uses charges $20 brokerage fee or 0.25% of the value purchased, whichever is higher. For this transaction, the brokerage will charge 0.25% x $10000, which equates to $25.

The second scenario is an investor who decides to employ a dollar-cost average strategy. He buys $5000 worth of shares today and another $5000 in three months’ time. His fees will add up to $40 based on two minimum charge brokerage fees.

As shown, the dollar-cost averaging strategy can lead to higher brokerage fees due to the minimum charge fees. Having said that, if an investor has a larger sum, and each transaction he makes is above the minimum transaction fee threshold, there would not be any additional cost to this investor.

Stocks trend upwards even in the short-term

The next aspect we will look into is whether we can save money by waiting three months before buying our next batch of stocks.

There has been a total of 100 quarters since 1993. Using data from MarketWatch, we can see that out of these 100 quarters, 64 of these ended with the S&P 500 index higher than the last. This means that 64% of the time, waiting to invest the next quarter would have reduced your overall returns as you would not be able to buy as many shares with the same amount of money.

Stocks tend to trend upward and waiting for the next month or next quarter to purchase a stock usually means that you will have to pay more for it.

Obviously, on the flipside, there was still 36% of the time that you would have managed to get more the next quarter as the index declined.

Over the long run, history dictates that you would have made slightly less with the dollar-cost averaging strategy.

The Foolish bottom line

Dollar-cost averaging can be useful for investors who wish to negate some of the risks of stock volatility. But history has shown us that waiting to buy shares at a later date usually mean you will be paying more for less, due to the upwards nature of stocks.

Furthermore, if the amounts that you purchase in each transaction do not hit the minimum threshold, you may, in fact, be paying more commissions to the brokerages using this investment strategy.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.