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 a method 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 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.
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 where investing a lump sum can be rather nerve-wracking.
How it works
Let’s use the ‘$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.
By sticking to a regular investment strategy during a fluctuating market, the investor ended up generating a larger return than if the full $6,000 was invested in one go. This is why some investors view dollar cost averaging as a less risky way of investing, because it spreads the cost of investing across a time period that you choose.
Keep in mind, however, that dollar cost averaging is not a risk-free strategy. Sometimes you’ll end up with a lower return than you would have if you’d invested your entire lump sum in one go, such as when the market is steadily rising over time.
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When can dollar cost averaging go wrong?
As the above example shows, dollar cost averaging works best for assets that have a fluctuating price, or where the price falls and then rises. By investing at regular intervals, you can possibly benefit from the volatility in the price of your chosen security over time.
The flip-side of this however, is that choosing to make use of dollar cost averaging when the market is about to go up could see your potential profit reduced. ‘Buy low, sell high’ is what any investor seeks to do, but by dollar cost averaging in a bull (rising) market, you’re buying low and buying high, which may not optimal. On the other hand, if you’d invested your full lump sum in one go, you’d potentially have been able to buy low, sell high, and then possibly laugh all the way to the bank.
Let’s look at an example of how dollar cost averaging can play out in a bull market:
|Month||Investment||Share price ($)||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.
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 risk, 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.
While it’s not quite as exciting as trying to game the stock market, putting money in your super can be one of the most prudent investments you can make – but you should make sure you’re with the right fund first. You can compare funds and find the best one for you with Canstar.