What is Dollar Cost Averaging?

So for those of you who may not have heard of this term 'dollar cost averaging' already lets firstly talk about what this actually means. When you make investments you can put a sum of money into the investment like $1000 in one go which is often called a 'lump sum investment' and or (you can do both) put a $100 in every month for 10 months which is called cost dollar averaging.

All dollar cost averaging means is putting a fixed amount of money into an investment at regular intervals and this is thought of as being a good investing strategy.

Why would I do cost dollar averaging?

In terms of the stock market, If you set your investment plan up so that a fixed amount comes out of your bank account and gets invested every single month let's say then you are committing to purchasing stocks regardless of the market and it's volatility. So you may end up buying stocks when they are low or even very high.

By purchasing an asset in one go with one lump sum amount like buying stocks in the S&P 500 today you are buying it at one set price. Whereas if you purchased these periodically every month then you are reducing the impact of short term volatility of a market because you may buy one month at a high price and the next at a low price which then can balance each other out. This is also seen as being beneficial because it means you're not having to sit and time the market and wait until you see a good price which of course you may end up judging wrong and paying too much for. Dollar cost averaging is a good way of removing the psychology and personal emotions from investing.

If you’re dollar-cost averaging, you’ll be buying when people are panic selling (which can happen when prices start dropping), this means you'll be getting a good deal and setting yourself up for strong long-term gains.

Let's take a look at an example to make things clearer.

Example:

Let's say Mr Invest has $1000 to invest in the X index.

The first scenario involves him putting all that $1000 into the market on 1st August. On this day the price of a single stock was $5 so he got 200 shares. Let's be positive and say the index does well and in 3 months the sell price per share is now at $10 so now he can sell his shares and he would sell them for $2000 meaning he profited $1000.

The second scenario involves Mr Invest putting $100 into the market each month for 10 months. One month the price may be $4 a share and another month maybe $6 and another maybe $3.50. He doesn't think about the price and simply commits to buying $100 worth of shares once a month. When the 10 months is over he has spent $1000 and got 215 stocks. Let's be positive again and say the index does the same thing and in 3 months the sell price per share is $10 so now if he sold his shares he would make $2150 so he would have made $1150.

Because he owns more shares than in a lump-sum purchase, his investment grows more quickly as the stock’s price goes up. I know this is an unrealistic example and relies on the outcome of the market having increased but it gives an idea. The market can of course decrease.

Drawbacks of dollar-cost averaging:

As with anything there are some downsides to cost dollar averaging however I don't think these are downsides for everyone:

1. Buying more frequently adds to trading costs - if you're having to pay a fee every time you buy a stock then this may not be preferable however it's unlikely that this will be a big deal if you're planning to invest for the long haul.

2. You could miss buying stocks when they are incredibly low and therefore may miss out on earning as much when prices rise if you had invested in a lump sum.by dollar-cost averaging. However, the success of that large purchase relies on timing the market correctly, and investors are notoriously terrible at predicting short-term movement of a stock or the market.

Cost dollar averaging vs lump sum:

I'm not going to say dollar cost averaging is better than lump sum investing or visa versa as they both have their place. Investing a large amount of money can be quite risky and scary to some people especially for first time investors which is where cost dollar averaging can be quite good. Having said this, I read that Vanguard did a study back in 2012 - can you believe 2012 was nearly 10 years ago ! - and found that on average lump sum investments outperformed dollar cost average as a strategy across a 12 month period and again over a 10 year period. I guess this is because stock markets rise over time so putting in money as earlier as possible to begin building compound interest and work for you can often generate higher returns rather than holding it back and putting it in periodically. But if you can only afford to invest $100 once each money then this is a great option too!

I think whether you decide on a lump sum investment strategy, cost dollar averaging or a mixture of both is fine. I hope this post was helpful!

Thank you for reading!

Hayley