Dollar-cost averaging can be an effective way of managing share investing risk – provided you’re patient.
Put simply, dollar-cost averaging is an investing term that describes the strategy of making incremental investments over time, rather than investing all at once in a lump sum. The idea behind it is that you can reduce the impact of market volatility by investing over a longer period.
It’s essentially what happens with your superannuation. You, or your employer, make contributions over time, which are invested incrementally.
How dollar-cost averaging works
Instead of investing all of your money at once, you invest smaller, fixed amounts on a regular basis over a period of time.
For example, you might have $5,000 to invest. Instead of investing the full $5,000 in one transaction, you invest $1,000 per month over the next five months. During that five month period, the price of the asset you’re buying may go up and down, but you always invest the same amount, regardless.
What happens over the five months is that you end up buying more of the asset when the price falls in any given month, and less if the price is higher. That’s because when prices are high your money can only afford you a certain number of assets, but as the asset price drops you are able to afford more of them.
Dollar-cost averaging therefore reduces the risk of buying too much of an asset at a time where prices are particularly high, while allowing you to buy more of an asset during a market downturn.
Is dollar-cost averaging a good strategy?
Often, deciding whether to employ a dollar-cost averaging strategy is an emotional decision rather than a financial one. Timing the markets is tricky, and even experts can get it wrong. So, it can feel safer to invest in an asset over time, meaning you get the market average.
For example, if you invest $100,000 today and the share price drops 20 per cent tomorrow, it can feel like you’ve lost $20,000 before you’ve even started. But it’s important to remember that investing is a long-term activity. A little patience can go a long way as today’s price isn’t where you will end up over time.
If you are looking for short-term gains, you’re speculating not investing, which is a different game altogether.
It can help to manage risk in some circumstances
Dollar-cost averaging can be a suitable strategy when you need to minimise risk. For example, in the latter years of your working life when you don’t have time to recoup losses. Or if you are investing an unexpected windfall, such as an inheritance.
Additionally, it involves time out of the market and typically, research shows that lump sum investing yields better long-term results. This is particularly true in today’s low-interest environment, where money in the bank generates little in the way of returns.
Time in the market, not timing the market
If you are looking to invest long-term, the metric you should be looking at is your time in the market, not trying to time the market. If you have the time to weather market movements before you need access to the funds, you’ll most likely yield better results over time with a lump sum strategy. That’s because you have more money invested for a longer period of time.
However, it’s important to remember that the best investment strategy for you depends on your circumstances and your goals, which are different for everyone. That’s why working with an adviser is essential – they take the time to understand your personal context to help you make the right decision.
This is an edited version of an article that originally appeared on Apt Wealth Partners and is republished here with permission. This article contains general information only. It should not be relied on as independent finance or tax advice. If you are after specific professional advice, speak to your registered tax agent/financial advisor or reach out to Apt Wealth Partners.