Thinking of investing a lump sum of money? Dollar cost averaging is the term used to describe the strategy of making regular investments incrementally instead of investing a lump sum at one time.
When looking at getting into investments such as shares or managed funds, the thought of your investment crashing in value can be rather daunting, especially if you’ve got a sizeable lump sum on your hands ready to invest. Dollar cost averaging is an investment strategy that can be suitable for both experienced and new investors to reduce their risk of seeing their investment slump in value.
What is dollar cost averaging?
Dollar cost averaging (known as DCA) can be a great alternative to investing a lump sum. Instead of investing all of your capital in one go, the idea is that you invest smaller, fixed amounts on a regular basis over an extended period of time. For example, instead of investing $6,000 in one transaction, you could invest $1,000 per month over six months. The price of the asset you’re buying may go up and down over that period, but you always invest the same amount. What happens is that you end up buying more of the asset when the price falls in any given month, and fewer units if the price is higher.
You might have heard the saying that “Time in the market is more important than timing the market”. This is where DCA comes in. You may want to buy more shares when the share price is low, but timing the market to find the bottom of the dip is very difficult – even for experienced investors! Or, perhaps you’ve been saving enough money to buy your first bundle of shares, and by the time you have enough, the share price of the stock you’re wanting to buy has steadily increased. Dollar cost averaging alleviates the need to find the bottom or top of a share price.
Dollar cost averaging can in some cases take away the ‘timing risk’ of trying to pick the bottom of a market, and can possibly offer benefits in volatile or hard-to-predict markets when investing a lump sum can be rather nerve-wracking.
How does dollar cost averaging work?
Let’s use the hypothetical ‘$6,000 over six months’ example – say an investor wants to put money in Company X, but its share price has been rather up and down lately. The investor decides to make use of dollar cost averaging over a six month period, investing $1,000 every month regardless of the share price. This is how it goes for the investor:
|Month||Investment||Share price ($)||Units purchased|
|$6,000 invested||Average share price: $3.9344||Total units bought: 1,525|
Rather than investing the entire $6,000 in the first month and ending up with 750 units, the investor using dollar cost average has staggered the investment over a period of six months – and because the share price moved up and down over the period, ended up buying 1,525 units. And while the price of the share dropped as low as $2 at one point, at the end of the six-month period the share was worth $6.66, meaning that the portfolio of 1,525 units is worth $10,156.50 at this time. If the investor had instead invested as a lump sum at the beginning of the period, the 750 units would be worth $4,995, meaning the investor would have actually made a loss on the investment at this point in time.
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By sticking to a regular investment strategy during a fluctuating market, the investor ended up generating a larger return than if the full $6,000 was invested in one go. This is why some investors view dollar cost averaging as a less risky way of investing because it spreads the cost of investing across a time period that you choose.
Keep in mind, however, that dollar cost averaging is not a risk-free strategy. Sometimes you’ll end up with a lower return than you would have if you’d invested your entire lump sum in one go, such as when the market is steadily rising over time.
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When can dollar-cost averaging go wrong?
As the above example shows, dollar cost averaging works best for assets that have a fluctuating price, or where the price falls and then rises. By investing at regular intervals, you can possibly benefit from the volatility in the price of your chosen security over time.
The flip side of this, however, is that choosing to make use of dollar cost averaging when the market is about to go up could see your potential profit reduced. ‘Buy low, sell high’ is what any investor seeks to do, but by dollar cost averaging in a bull (rising) market, you’re buying low and buying high, which may not optimal. On the other hand, if you’d invested your full lump sum in one go, you’d potentially have been able to buy low, sell high, and then possibly laugh all the way to the bank.
Let’s look at a hypothetical example of how dollar cost averaging can play out in a bull market:
|Month||Investment||Share price ($)||Units purchased|
|$6,000 invested||Average share price: ~$12.60||Total units bought: 476|
If the investor had put the full $6,000 in the security of choice to begin with, by the end of the six-month period they would own 750 units worth $11,715 in the current market. But by dollar cost averaging over that same period, the investor has ended up with 476 units worth a total of $7,435.12. While the investor has still made a profit on their investment, it’s a smaller one than they would have by investing a lump sum at the beginning of the period.
So, is dollar cost averaging a worthwhile strategy?
At the end of the day, your investment decisions should always be guided by your investment goals. Trying to time the market for short-term profit can pay off (literally) if done well, but it can carry a lot of risks, so if you’re looking for long-term wealth creation your approach would typically be different and month-to-month price fluctuations will be of less concern. While past performance is no indication of future performance, investment markets generally rise over the long-term despite the short-term volatility, so keep that in mind when thinking about investing money in shares or any sort of security.
Original Author – James Hurwood
Cover image source: Raterman/Shutterstock.com