In a nutshell, dollar cost averaging is an investment strategy that can minimise your risk.
When it comes to trading shares, the old adage of buy low sell high seems to make perfect sense. But no one can predict the future and even investment professionals struggle to time the market correctly.
As for everyday investors, trying to pick a share’s peaks and troughs can feel like a game of pin the tail on the donkey.
Dollar cost averaging is one investment strategy that can reduce timing risks associated with the sharemarket.
What is dollar cost averaging?
It’s an investing strategy that involves investing the same amount of money at regular intervals, regardless of the price of the investment at the time.
So dollar cost averaging should reduce the impact of market movements on the value of your investment. It protects against the risk of prices moving lower after your initial purchase.
This strategy can be used to break down a lump sum of money, or invest ongoing fixed smaller amounts (like a portion of your salary).
Over time, it should lower the overall cost of investing. It puts your money to work on a consistent basis, which is a key factor in successful long-term investment growth.
How it works
Say you have $10,000 and are looking to buy a particular share.
Investing it all now exposes the entire amount to fluctuations in the share price (good or bad).
A dollar cost averaging approach, however, might involve investing $2,000 a month for the next five months at whatever price the share happens to be at.
If the share price drops for a couple of months, you’ll pick up more shares at a lower cost, which will gain in value quicker if the price picks up and reduce the average cost of your investment.
It works because over the long term, asset prices tend to rise. Just be aware that by making more trades, you’ll pay more in brokerage costs, so factor these in.
When is dollar cost averaging effective?
Dollar cost averaging is a disciplined approach to investing. It manages risk and allows investors to get money into the market without having to worry about timing.
While it can reduce overall returns in rising markets, there are psychological benefits to being protected against immediate downside risk.
It can also foster a more long term approach to investing as there’s less incentive to buy or sell speculatively.
Finally, most people don’t have large amounts of money to invest. So regularly investing smaller amounts is a great way to build up a portfolio over time.