Dollar Cost Averaging
Buy low and sell high is an understandable goal, but it’s easier said than done.
After all, if you could consistently buy low and sell high, you would never have to work for a living. A more workable investment strategy, based on the same ideal, is called “dollar cost averaging.” It’s a discipline that helps investors invest more efficiently.
Dollar cost averaging means you invest a specific dollar amount in your investment portfolio regularly. By doing this, you’re investing systematically, which allows you to remove the emotional element and any desire to time the markets from the equation. It’s a simple approach that can be surprisingly liberating.
How dollar cost averaging works
With dollar cost averaging, you commit to invest a set dollar amount on a regular basis and stick with this approach through both good and bad markets. This discipline is easy to maintain, especially when you invest automatically through payroll deductions or automatic payment.
When market prices fall you automatically buy more units in the funds with each subsequent investment. When prices start to rise, you buy fewer units. Because you're buying more units when prices are lower, and fewer units when prices are higher, the average cost of your units will be below the average market price of all the units (see table).
Dollar cost averaging cannot guarantee a profit or protect you against a loss in declining markets. However, a commitment to dollar cost averaging does reduce the odds that you will invest a large sum when the market has just hit a high point. Perhaps the best thing about dollar cost averaging is that it’s a technique that eliminates the emotional factor from your investment program.
Consider this, many people become nervous about investing in the face of “choppy” markets. 2020 provided a prime example; global equity markets significantly fell in value as the pandemic escalated, before rebounding strongly to new highs by year end.
Reluctance to invest is natural, nobody likes to be reminded that investment markets go down as well as up. But at the end of the day past events tell you very little about the future. And failure to invest could be just as bad as investing at the wrong time.
This is where dollar cost averaging comes in.
By investing over time, you insure yourself against a large fall in the asset values early in the program. If markets fall toward the end of your savings program, at least you will have made money on your early savings. This way, you minimise the anguish often associated with new investments.
The hypothetical example below shows how dollar-cost averaging can work. Let’s say an investor decided—with the help of their financial advisor—to invest 1,000/month for a total investment of $12,000 over one year. By dollar-cost averaging, the investor bought 1267.09 shares at an average cost of $9.47/unit, which is below the average market price of $9.63/unit, essentially smoothing out the up-and-down price swings. The maths works out like this:
|INVESTMENT DATE||INVESTMENT AMOUNT||UNIT PRICE||UNITS PURCHASED|
(total units purchased)
Hypothetical analysis provided for illustrative purposes only, it does not reflect the performance of any actual investment.
As you might expect, there are arguments for and against dollar-cost averaging in the investment industry. Many believe that the most efficient way to invest is to put an entire lump sum to work immediately to achieve the best outcome.
While this may be true from a theoretical standpoint, an investors experience will depend on how markets play out. Using the examples in the table, if you had gone all-in at the beginning of April, you may be feeling some buyer’s remorse by getting in at $12.00 — the hypothetical high. It would have been nice to invest at the hypothetical low of $7.50 in September, but that would have been pure chance. As such, dollar cost averaging can be thought of as a risk management technique that helps investors avoid the consequences of timing investments poorly, but comes at the trade-off of missing out timing the markets well.
Chances are that over a long period of investing you will not remember the early wobbles. But short-term movements can be very hard on new investors. Remember, the goal is not to time the market by picking a high or low price, but to simply smooth out investment over time. Work with your adviser to develop a good strategy – and stick with it.