What is dollar-cost averaging?

While no one knows for certain whether a share price will go up or down, dollar-cost averaging helps investors hedge their bets over time. Here’s how the investment strategy works.

How to dollar-cost average

All investors want to buy low, just as they hope one day to sell high. However, that’s easier said than done. In fact, studies show that investors are terrible at timing the market and planning their entries into, and exits out of, the market (eg. when to buy and when to sell).

To avoid paying too much, many long-term investors use a technique called dollar-cost averaging (DCA). This involves regularly investing small amounts of money into the market as opposed to an equivalent lump sum all at once. The idea is that you’ll buy when the market is high and low but that over time, the price investors pay will average out.

Dollar-cost averaging versus market timing

If you’re regularly investing part of your salary, you may be already dollar-cost averaging without knowing it. Take Georgie for example who invests every time she gets paid by her employer. 

It helps that with Superhero’s low brokerage fees, investors can do so without having to worry so much about higher fees eating into their returns. Investors pay from A$2* to trade in the ASX and Wall Street. By taking advantage of this, investors like Georgie can buy shares more frequently and maximise their time in the market.

Let’s consider another example.

Say you have saved $10,000 and decide you’re ready to invest it. You have had your eye on a certain tech company and you’re excited to add it to your portfolio.

Rather than investing $10,000 all at once, you could dollar-cost average instead. For example you may decide to buy $2,000 in your tech darling once a month. Today you might buy it at $100 a share. Next month you buy another parcel at $120 a share, and then $110 and then $70 and then $90. 

By dollar-cost averaging, you bought a different number of shares at each interval. You received more when the share price was low and fewer when the share price rose. In other words, by making multiple purchases you avoid buying your desired shares at an especially high price.

Pros of DCA

There is of course no guarantee that spreading an investment out over time will mean you end up ahead. But there are some psychological advantages of dollar-cost averaging, particularly when share prices can fluctuate significantly day to day. 

Let’s go back to our example above for a moment. Let’s say instead of dollar-cost averaging, you invested your entire $10,000 in one go at $100 per share. Now let’s say the company suddenly announces some bad earnings or a defect with their latest product and the share price suddenly drops to $50. Your investment is now worth just $5,000.

Now if you’re investing for the long-term and believe in your investment, you wouldn’t be worried about short-term volatility but sometimes that’s easier said than done. If such a situation were to happen, some investors might panic and sell, locking in their 50% loss. In this instance, dollar-cost averaging may help them sleep better at night and stay the course.

Cons of DCA

However, here’s the rub. If you find yourself already holding onto a large lump sum, be it from an inheritance, a large windfall or just from saving diligently, then some research suggests dollar-cost averaging may not necessarily be the best course of action.

One study found that over a ten-year time frame, investors who simply put all of their money into the market were better off nine times out of ten than those who put it in bit by bit. 

Why? Because by not investing you’re missing out on one of the most important phenomena in investing: compounding over time. 

By investing today, investors maximise their time in the market. While no one knows when the next market crash may happen, they do know the market has risen over time – Australian shares have risen 9.55% per year on average over the last three decades.

Another disadvantage with dollar-cost averaging is that if you’re paying brokerage on every trade, these fees may add up over time and lower your overall returns.

The final word on DCA

Obviously you can’t invest money you don’t have. If you’re investing your salary, dollar-cost averaging is a great strategy for gradually building up a share portfolio.

On the other hand, if you have a lump sum burning a hole in your pocket, research shows you may be better off investing it all at once rather than over a long period of time. 

However, make sure you’re mentally prepared to deal with the possibilities of a sell-off or market correction. If you could do without the stress, DCA-ing might still be the ticket to a good night’s rest.