What is Dollar Cost Averaging?

What is Dollar Cost Averaging?

If you have been investing in shares for some time, you would know that investors draw upon a variety of strategies and considerations when purchasing shares. While many of these approaches boil down to fundamental or technical analyses, dollar cost averaging (DCA) is an investment strategy that in some ways sits in its own realm.

For those unfamiliar with the concept, dollar cost averaging involves investing in shares by purchasing the same monetary amount in a particular stock at regular intervals. Equal instalments spread some of the risk associated with trying to ‘time’ the market and instead focuses on allocating one’s investment over a broader time horizon.

With dollar cost averaging there is no particular emphasis on how the stock is behaving or what the broader market is doing. As an example, you might invest $5,000 in Rio Tinto (ASX: RIO) on the last Friday of each month for six months. Due to the fluctuations in the share price, you will acquire a higher number of shares each time when the share price is below the original price you paid, and less shares when the stock price is trading higher.

On the one hand, this method of investing in shares involves no technical analysis. The decision to buy is based on an arbitrary ‘rule’ stipulating the day or date you make each purchase. On the other hand, the decision to invest additional capital towards a particular stock does not necessarily entail fundamental analysis each time a subsequent purchase is made.

 

 

What are the advantages of dollar cost averaging?

From a risk management perspective, dollar cost averaging can help ensure that you’re not putting all your eggs in one basket as far as the timing of your entry.

With respect to an investor’s mindset, DCA may assist you in managing any stress or emotion associated with making an investment decision. After all, you have committed to a disciplined approach where you will be regularly investing in shares, irrespective of trading conditions that prevail at the time.

In the event that the stock drops, you benefit from the fact that you didn’t allocate all your capital at the higher price. Assuming the company’s long-term prospects remain promising, this strategy can also lower your cost base in anticipation of a rebound, in which case subsequent gains would be magnified.

In fact, dollar cost averaging has been a popular strategy among SelfWealth members throughout the recent market rout. It may be viewed as a practical way to budget some of your income for investing in shares.

 

What are the disadvantages of dollar cost averaging?

While offering some benefits, dollar cost averaging is far from foolproof.

First things first, if you have committed to dollar cost averaging in an effort to adopt a more hands-off approach, you might find that your ‘detachment’ from any change in the fundamentals of the stock could cost you if there has been a material change in the company’s outlook. Therefore, you would still be investing in shares that may remain stagnant for a long time or continue declining.

Another thing to consider is your opportunity cost. Since DCA involves committing your capital to one stock, you might miss other opportunities that offer more lucrative upside, especially if you have pared back your research due to putting more faith in a particular stock. This may be mitigated, however, by dollar cost averaging across a diversified portfolio.

Nonetheless, the above point ties in with another issue. In a rising market, each successive purchase may end up being at a higher price than the last. Although there is nothing specifically wrong with averaging up, again, you should consider whether there are ‘better’ opportunities being overlooked each time you enact your dollar cost averaging.

Finally, it’s helpful to have some statistical context into the performance of this investment strategy.

On that front, prior research from Vanguard spanning between 1926 and 2011 found that in 67% of instances lump sum investing outperformed dollar cost averaging across rolling 10-year periods.

Similarly, a study by Kowara and Kaplan analysed data between 1926 and 2019 and concluded a result even more lopsided, with lump sum investing outperforming DCA over an average 10-year period nine out of ten times.

 

 

Does this mean lump sum investing is better?

While the above statistics point to a fairly resounding result, it’s still difficult to conclude that lump sum investing is ‘better’ than dollar cost averaging. There have also been studies where dollar cost averaging outperformed lump sum investing, albeit typically across a specific timeframe, such as the early 2000s where there were two bear markets within a 10-year period.

On top of all this, one reason for all the ambiguity in terms of the ‘better’ strategy for investing in shares is due to the fact that shares have different profiles. While broader market movements will influence individual stocks, they also tend to respond to individual events. In addition, the right strategy will depend on your confidence levels, your investment horizon and the amount of capital you have available to invest.

One benefit of lump sum investing, however, is that you put your cash to work immediately. You will also reduce your brokerage expenses and gain full exposure to any dividends declared straight after your initial entry.

The downside to lump sum investing is that you require greater conviction in your investment decision because you are taking on far more risk and potentially heightened volatility. To finish with an example, few investors would look back fondly upon the idea of lump sum investing in Flight Centre (ASX: FLT) or Webjet (ASX: WEB) shortly before COVID-19. Are you confident trying to ‘time’ the market?

 

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SelfWealth Ltd ACN 52 154 324 428 (“SelfWealth”) (Australian Financial Services Licence Number 421789). The information contained on this web site is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. Taxation, legal and other matters referred to on this website are of a general nature only and should not be relied upon in place of appropriate professional advice.

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