Hollywood has given us a false perception that successful investors throw all their money in at exactly the right moment and then cash out again at the exact right moment. Easy money, right?! In reality, it’s virtually impossible to perfectly time the market, and going ‘all in’ comes with a lot of risk. Dollar-cost averaging is an investment strategy that takes timing out of the equation, helps to minimise risks, and shields investors from the monetary (and mental!) highs and lows of share market fluctuations.
What is dollar-cost averaging?
Put simply, dollar-cost averaging is when you invest the same amount of money in a company or fund at regular intervals. Many investors don’t have the time or the skills to closely monitor share prices for months and months, trying to calculate the best time to buy. A dollar-cost averaging example is finding an investment you expect to be worth more in the future, and investing in it at regular intervals over a long period of time.
If you’re in Kiwisaver and making regular automatic contributions every pay, guess what; you’re already dollar-cost averaging!
How dollar-cost averaging works
Say an investor buys $300 worth of shares in a specific company or ETF every month. In the months where the share price is low, they’ll get more shares for their $300, and in the months where the price is high, they’ll get fewer shares. The idea is that shares bought when the price is low, will bring down the average price paid per share over time.
So, let’s pretend you've found an ETF you want to invest in. You could wait and hope you guess correctly when the price hits rock bottom, then scoop up a bunch of shares at once. Or, you could use dollar-cost averaging to buy your investments over time.
Let’s say you opted to invest $300 every month for five months:
- The mean average share price over the past five months was $49.20
- The mean average price you paid was $48.31 - Because your monthly $300 invested bought more shares when the share price was lower, the average price you paid is lower than the overall average price (divide the $1,500 invested by the 31.049 shares you own).
By investing a fixed dollar amount, rather than buying a fixed number of shares every month, you have wound up with more shares! But wouldn’t it have been better to invest a lump sum in the first month when the price was at its lowest? Let’s dig a little deeper and compare dollar cost averaging versus lump sum investing.
Dollar cost averaging vs lump sum
Using our dollar-cost averaging example above, you would have been better off investing a lump sum in month one. However, it’s also possible that you’d have seen the $40 price tag in month one and thought “oh I’ll wait for a better deal” - then panic bought in month two. In the latter scenario the average share price you would have paid would be higher than the average you’d pay by dollar-cost averaging.
All share prices cycle through highs and lows, and trying to guess the top and bottom is much harder (and as studies have proven, less effective) than riding out the waves and getting those lows to decrease your average price.
Is dollar-cost averaging worth it?
Like any investing strategy, deciding if dollar-cost averaging is right for you depends on your unique situation. Let’s look at the pros and cons of dollar cost averaging so you can decide if it’s a strategy you’d like to use.
Advantages of dollar-cost averaging
Dollar-cost averaging can help you to avoid emotional investing. While short-term and lump sum investor friends will be watching stock charts on the daily, ready to react to price fluctuations, you can go about your life and leave your investments to do their thing.
Obviously, when a company’s shares drop in value, it’s easy to worry that there’s something wrong with it. This is why it always pays to do your research, and believe in the company you’re investing in. If you think it’s fundamentally a solid investment for the long-term, a drop in share price in the short-term shouldn’t change that.
Disadvantages of dollar-cost averaging
Investing carries risk, and one of the risks of dollar-cost averaging is that the market could be rising while you invest. In this scenario, the average price you pay will keep increasing, which is not ideal!
If you’re the type of investor who enjoys spending time on research and trying to time the market, dollar-cost averaging may not work to your advantage. If you have a specific buy price in mind for what the shares are worth, methods like lump sum investing or setting a limit buy order could be better suited to your investment goals than dollar-cost averaging.
Likewise if you’re investing for the short-term, dollar-cost averaging might not be the best approach for you because you’re looking for short-term growth rather than trying to reduce your average cost over time.
How else can dollar-cost averaging help me?
When investing in share markets, you’re not just dealing with share price fluctuations, you may also have exchange rates (FX rates) if you’re buying foreign shares. FX rates are just as hard to predict as share prices - and they’re just as vulnerable to influences from news and global events.
Similar to regularly investing in shares to smooth out price fluctuations, you can also set up regular deposits to temper exchange rate highs and lows.
Dollar-cost averaging is a common long-term investing strategy, designed to minimise risks and lower average investment costs over the long term. After learning how it works, seeing an example of dollar-cost averaging and going over a few pros and cons, you can decide if this is a strategy you’d like to use with your own investments.