Author: Marissa Hayden
Thinking of investing a lump sum of money? Dollar cost averaging (DCA) 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. DCA 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?
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 $6000 in one transaction, you could invest $1000 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 want to buy has steadily increased. DCA alleviates the need to find the bottom or top of a share price.
DCA can, in some cases, take away the timing risk of trying to pick the bottom of a market. And it can possibly offer benefits in volatile or hard-to-predict markets, when investing a lump sum can be rather nerve-racking.
How does dollar cost averaging work?
Let’s use the hypothetical “$6000 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 DCA over a six month period, investing $1000 every month regardless of the share price. This is how it goes for the investor:
|Month||Investment||Share price ($)||Units purchased|
|$6000 invested||Average share price: $3.9344||Total units bought: 1525|
Rather than investing the entire $6000 in the first month and ending up with 750 units, the investor using DCA staggered the investment over a period of six months – and because the share price moved up and down during the period, ended up buying 1525 units.
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 1525 units is worth $10,156.50.
If the investor had, instead, invested as a lump sum at the beginning of the period, the 750 units would be worth $4995, meaning the investor would have made a loss on the investment.
By sticking to a regular investment strategy during a fluctuating market, the investor ended up generating a larger return than if the full $6000 had been invested in one go. This is why some investors view DCA as a less risky way of investing, because it spreads the cost of investing across a fixed time period.
Keep in mind, however, that DCA is not a risk-free strategy. In a steadily rising market, DCA could deliver a lower return than investing a lump sum in one go.
When can dollar cost averaging go wrong?
As the above example shows, DCA works best for assets that have a fluctuating price, or when the price falls and then rises. By investing at regular intervals, you can possibly benefit from the volatility in the price of your chosen security over time.
The flip side of this, however, is that choosing to make use of DCA when the market is rising could see your potential profit reduced. “Buy low, sell high” is what any investor seeks to do, but by applying DCA in a bull (rising) market, you’re buying low and buying high, which may not optimal.
Let’s look at a hypothetical example of how DCA could play out in a bull market:
|Month||Investment||Share price ($)||Units purchased|
|$6000 invested||Average share price: $12.60||Total units bought: 476|
If the investor puts the full $6000 in their security of choice at the start, by the end of the six-month period they would own 750 units worth $11,715. But by using DCA over the same period, the investor ends up with 476 units worth a total of $7435.12. While the investor has still made a profit on their investment, it’s smaller than the one they would have earned by investing a lump sum at the start.
So, is dollar cost averaging a worthwhile strategy?
Ultimately, your investment decisions should always be guided by your investment goals. Trying to time the market for short-term profit can pay off if done well, but it can also carry a lot of risks. So if you’re looking for long-term wealth creation, your approach should typically be different, and month-to-month price fluctuations less concern.
While past performance is no indication of future performance, investment markets generally rise over the long-term despite short-term volatility, so keep that in mind when thinking about investing money in shares or any type of security.
About the reviewer of this page
This report was reviewed by Canstar’s Editor, Bruce Pitchers. Bruce has three decades’ experience as a journalist and has worked for major media companies in the UK and Australasia, including ACP, Bauer Media Group, Fairfax, Pacific Magazines, News Corp and TVNZ. Prior to Canstar, he worked as a freelancer, including for The Australian Financial Review, the NZ Financial Markets Authority, and for real estate companies on both sides of the Tasman.
Enjoy reading this article?
You can like us on Facebook and get social, or sign up to receive more news like this straight to your inbox.