Dollar-Cost Averaging: a Legitimate Strategy on eToro?

With the rising popularity of trading worldwide there are many strategies available and advertized to choose from. The vast majority of them however focus on short-term gains and rapid returns rather than a long-term outlook. Although one should not necessarily forego fastly emerging opportunities in the market, becoming familiar with a long-term wealth creation strategy may be equally important for trading on the eToro platform. Below you can find a quick guide to a relatively simple strategy of dollar-cost averaging.

(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings.  In fact, Around 68% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)

Dollar-Cost Averaging Strategy

Dollar-cost averaging is quite a popular strategy which aims to neutralize the effects of market volatility on a portfolio. Under this strategy trading of various assets is spread out across a time interval and purchasing occurs at regular periods and equal monetary amounts (given that these funds are available to you). This strategy is thought to be the complete opposite of an initial lump sum investment.

How does it work?

As previously mentioned, the purpose of this strategy is to keep the monetary amount of regular investment into an asset or a collection of assets constant. This means that any impacts of movements in the price of this asset are not taken into account in any way.

For example, you decide to invest an amount of $100 constantly every month (that amount is artibitrary and used just as an example). Therefore even if the price of the asset rises at the time of one of the purchases, fewer stocks or assets shall be purchased as the money you are investing will buy fewer units of the now more expensive instrument. So for example if the share price is $10 in January, you will be able to buy 10 shares while if it increases to $20 you will only be able to purchase 5. On the other hand if the share price decreases then the same amount of money should allow you to buy a larger volume of assets; if the price drops to $5 per share you can buy as many as 20.

Why is it called dollar-cost average strategy then?

Well, as you are able to purchase a larger volume of shares when the price of the asset declines and fewer shares when they are expensive, the average cost per share of your total investment decreases accordingly. Hence in the long-term on average the average cost of shares should decline. Bear in mind though that is how the strategy is meant to work out but there is always a chance of capital losses.

In the long-term, prices of assets do tend to rise but this increase is not constant in the short-term and that is what makes the strategy work. But let’s consider an example.

Let’s say you plan on purchasing a certain amount of shares in January, investing a total of $1200. The two options that you face are investing the entire amount initially (also known as a lump-sum investment) or spreading the purchases over a year using the dollar-cost averaging strategy, sp lets say with payments made every month. You then choose to spend $100 for example every month according to the strategy as shown in the table below.

As we can see from the table, if you have made your purchases periodically instead, you would have purchased 121.27 shares over the time period with an average cost of $9.89. This is 0.11 dollar cents less than the initial lump sum spending strategy. (Do bear in mind that these is an arbitrary example of how the strategy is meant to work out and does not necessarily represent a real world example; markets are extremely volatile and there is always a chance of capital losses) If you have had employed your entire investment amount to purchase all of the shares in January, you would own 120 shares after 12 month at a price of $10 per share.

How would you implement it on eToro?

There are a wide variety of assets available for investing on the platform so you can always choose the one most suitable for your preference. Let’s consider Apple stock as an example of dollar-cost averaging strategy here. You could certainly choose to invest the entire amount available at the beggining of the period, but one could employ the dollar-cost averaging instead.

Let’s say the strategy was being set up at the beggining of December 2019 and maintained until December of the next year, with a chosen time interval of one month (could be a different one of course). Then purchases of this Apple share would have been made at the beggining of every month for a certain amount of money suitable for your available capital. As you can see from the price chart the price of this stock is very volatile, so some months the investment amount would allow you to buy more shares (like April for example) and some months fewer (like September, where the price was at its highest). And that demonstrates the simplicity of the strategy: by default you would have purchased fewer shares when the price was high and more shares when it was low, so on average the cost declines as the strategy’s name suggests.

The platform makes it possible for traders with limited available capital too as there is always an option to buy fractions of shares, as shown below.

Dollar-cost averaging out

The opposite pocess can be applied to the process of selling as well as buying, reducing the impact of market volatilities on short positions taken over a period of time by averaging out the selling price. The image below shows the long (buy) positions in green and short (selling positions) in red. This strategy allows to both average in and out according to the same strategy and the average of potential profits can be received in this way.

Why is such a strategy used?

There are many reasons as to why one would choose to implement this strategy.

Dollar-cost averaging helps to mitigate the negative impact of psychological trading. Because the trades are timed and essentially planned out, there is virtually no space for irrational emotional behavior such as panic selling for example. As we’ve seen from the example of Apple on eToro, some month the price dropped quite a bit but that wouldn’t have affected your investment according to the strategy.

Furthermore, one doesn’t need a large initial capital to begin with and can gradually feed in their investment in proportion to the availability of funds. It also avoids the potential losses in case the timing of that one time big initial investment was incorrect if you have decided for a lump-sum initial investment instead. By gradually feeding in capital into your investment it helps in maintaining a certain degree of liquidity and essentially reduced risks to a certain extent. Buying the asset over a time period when its price is continuously declining could assist in generating potentially large returns (given that the market conditions are favorable in this way). One doesn’t need to spend the time and research analysing the market in an attempt to time and outperform it. Finally and most importantly this strategy has a long-term wealth creating investment outlook that you could implement on the eToro platform.

Downsides of dollar-cost averaging

Of course there are always certain downsides associated with every strategy. Because assets are purchased periodically there may be a chance of higher fees and transaction costs, but that certainly depends on the type of asset in question. Also, as you hopefully have realized, this strategy is quite rigid and lacks flexibility in adjusting to changing economic conditions or for example rebalancing. Finally, because this is quite a passive strategy which aims to minimize risks one shouldn’t expect very high returns from it. Certainly this type of strategy is not suitable for every investor.

As we have seen, dollar-cost averaging is a long-term strategy and is used to minimize risks by essentially ignoring short-term market volatilities when trading an asset or a portfolio of financial instruments on the eToro platform. Investment is done at pre-determined time intervals with a previously decided upon capital amount and in the long-term should (beware that this is not a guarantee and there is always a possibility of losses) end up in a lower average cost of the financial instrument invested into, however one should not forget the associated risks and drawbacks of the strategy. Hopefully, this article helped you to become familiar with the strategy and you can now fully enjoy practicing this on your eToro demo acount, best of luck!

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