Dollar Cost Averaging (DCA) is a time tested conservative investment strategy. There some variants of it, such as Value Averaging. I created a variant that I call Enhanced Dollar Cost Averaging (EDCA). Perhaps others have thought up the same thing. What are DCA and EDCA?
Dollar Cost Averaging is a strategy where someone invests a fixed amount of money at regular intervals in the same investment or investments. No attempt is made to time the purchases. This strategy is often used to purchase stocks and mutual funds. Consider what occurs if this strategy is used to purchase stocks.
Because the same amount of money is invested each time, a person ends up buying more shares of stock when the stock price drops and fewer when the stock price rises. In effect, there is a built-in stock purchase timer, the number of shares to buy is automatically determined. It is simply the fixed monetary amount (dollars, deutsche marks, francs, pounds, etc.) divided by the price/share. As a result, the average share cost is usually lower than the most recent stock prices on a rising stock and usually lower the initial stock prices on a falling stock.
Such a strategy works best on stocks with highly volatile prices. Naturally the stock should be one which rises in the long run (five or more years).
For the small investor wishing to make monthly purchases of under $2000, this strategy can result in high commission costs - even if a discount broker is used. As a result many small investors only use this strategy in No Load Mutual Funds.
Enhanced Dollar Cost Averaging (EDCA) is very similar to Dollar Cost Averaging. However EDCA combines another strategy called "Buy on Dips." What is "Buy on Dips?"
Most investors want to buy when a stock is low and sell when it is high. As a result, some investors use the "Buy on Dips" strategy. They pick a company that they feel has a good long-term future (such as Dell, Microsoft, Boeing, etc.). These stocks tend to steadily rise in price. However all stocks drop in price at various times. Investors using the "Buy on Dips" buy the stock after a price drop appears to have bottomed out. How does one know when a stock has bottomed out?
Investors use various means to determine when a stock has bottomed. These include moving averages, envelope channels, price rate of change, P/E ratios, market price/book value ratios, momentum, and trading volume. I use some of these in addition to my own three proprietary technical indicators. The three indicators are variations of one technical indicator. One is for short-term trends (one day to a few weeks), one is for intermediate-term trends (a few weeks to a few months), and one is for long-term trends (a few months to a few years).
"Buy on Dips" is an effective conservative strategy, however it does have a short coming. Many times the stock will rise a great deal before having a significant drop. Even after the drop, the stock may still be much higher than since the prior significant drop. As a result, investors can often times obtain a lower price by using DCA. Combining "Buy on Dips" with DCA takes advantage of the strengths of both methods and reduces the shortcomings of both methods. I call my combination of DCA and "Buy on Dips" EDCA.
Not all stocks have their significant dips at the same time. This is especially the case with stocks in different industries. The stocks or mutual funds with the most significant dip for the month would receive the investment during that month.
Consider an example of 5 hypothetical stocks, named A, B, C, D, and E. The amount available to invest each month is $1000.
In January there is the following price movement (as measured from the stock's recent high):
In February there is the following price movement (as measured from the stock's recent high):
In March there is the following price movement (as measured from the stock's recent high):
With EDCA one invests $1000 into stock D at the end of January, $1000 into stock E at the end of February, $1000 into stock B at the end of March, etc. If there is a tie between stocks, then the $1000 would be split evenly among them for that month. For example, consider if four stocks are each down 10% with the remaining stock down less or actually up. Then $250 would be invested into each of the four biggest % downers.
The DCA characteristic of investing a fixed amount each is satisfied ($1000/month in this example). The "Buy on Dips" characteristic of investing in stocks with big percentage drops is also satisfied.
Using this approach could result in the portfolio becoming heavily weighted in certain stocks. This could occur if certain stocks had big % drops and stayed down for a long time. To prevent a prolonged imbalance, the investor may wish to invest in the second and third most downers at times. Or, the investor might momentarily switch to a pure DCA strategy.
There are other variations of the EDCA strategy that an investor could think up and use.
Many investors are drawn to the stock market for two reasons. One reason is to obtain excitement an the other is to make money. Speculative stocks can be exciting, but they also tend to be highly risky. As a result, it is often best to limit speculative investments to only a small percentage of one's total stock portfolio. The remainder of one's stock portfolio should consist of the stocks (or mutual funds) of strong companies. Doing so should reduce volatility, risk, and emotional stress. This latter effect is more important than it may seem, since fear, anxiety, and greed often cause an investor to make poor investment decisions. Investors sometimes have a logical investment strategy. But when destructive emotions are present, investors tend to deviate from their good strategy. Likewise stress is unpleasant in itself and can cause difficulty in sleeping. So you may wonder, how does one identify strong companies?
For purposes of investing, my definition of a strong company is one that has steady growth in sales revenue, earnings, and unit sales. It has a dominant market share that is at least holding steady (or a steadily growing market share in the case of those with only minor market share). It also has excellent marketing/brand name recognition. In addition, you must be at ease with buying the company's stock (or mutual fund) and holding it for at least five years.
Companies that meet these criteria tend to have stocks with low volatility and a steadily increasing stock price (at least when viewed on a monthly chart or other long-term charts). I prefer to view the stock (or mutual fund) on a chart with a logarithmic scale, instead of the typical arithmetic scale. A stock with a constant percentage growth rate appears as an exponential curve on an arithmetic scale, but as a straight line on a logarithmic scale. Viewing a stock on a logarithmic scale makes it easy to determine the degree of constancy and magnitude of the stock price growth rate.
Many of the stock selection criteria, mentioned above, are included in the C-A-N S-L-I-M method of stock selection. The C-A-N S-L-I-M method was created by William J. O'Neil, the founder of the "Investor's Business Daily" financial newspaper. The letters stand for the characteristics the stock should meet (in the opinion of William O'Neil). "C" and "A" are for strong current and annual earnings respectively. "N" is for new products, new management, and new highs in stock price. "S" is for small (or reasonable) number of shares outstanding. Mr. O'Neil is not in favor of older large capitalization companies, however I don't disapprove of such companies. Small companies do have greater potential for rapid growth, but they also are less likely to have track records of more than ten years. "L" represents leadership. "I" is for institutional sponsorship and "M" is for the general market.
More information about the C-A-N S-L-I-M method can be found in Mr. O'Neil's book entitled "How to Make Money in Stocks - A Winning System in Good Times or Bad." Additional information can be found in the "Investor's Business Daily" financial newspaper.
DISCLAIMER: The decision regarding whether or not to use any of the strategies mentioned above, is yours to make. Neither I, nor this web site, nor "Gavin Young's Investment Information Services," nor "The Phoenix Arises - News Analysis of Apple Computer," accept any responsibility for the outcome. The publisher takes reasonable care to assure the accuracy of the information contained herein but is not responsible for any errors or omissions. Any opinions expressed herein are statements of the editor's judgement as of the date of publication and are subject to change without notice. Information is merely provided to be of assistance to investors and should not be construed as a buy or sell recommendation. Readers should weigh matters carefully and use their own best judgement in making a decision suitable for their particular circumstances.