When markets are volatile and spare cash is not flowing freely, setting aside money to invest in your future might not be a top priority. But continuing to invest, in whatever small way you can, can make good sense in the long run.
Enter dollar cost averaging, an approach to investing that doesn’t require a large lump sum or nerves of steel.
How does it work, and what are the trade-offs? We take a look below.
How dollar cost averaging works
Rather than investing a lump sum of money at one time, dollar cost averaging is essentially investing smaller ‘bite-sized’ fixed dollar amounts into an investment at regular intervals, no matter what the unit or share price is doing at the time. The aim is to minimise the potential market timing risk of investing a lump sum amount at a given time.
Through dollar cost averaging, more units or shares are purchased when prices are low, and less units or shares are purchased when prices are high. The idea is that over the course of the investment timeframe, there are multiple entry points, and potentially a lower average price paid for the total amount of units or shares purchased.
It can be a useful strategy to help take the emotion and stress out of investing. Because dollar cost averaging is automated and structured, it can help take away the worry and also feelings of regret if you invest a lump sum right before a market downturn, or miss out on an upswing. Importantly, this ‘bite sized’ approach can also give your investing some momentum without the need to find a lump sum of money (which can be useful if you don’t have it).
Dollar cost averaging can tend to work best when you are prepared to patiently ride investment market volatility, and stick to the plan. Here’s a simplistic example based on the purchase of shares:
|Month||Investment||Share price||Shares purchased|
Let’s say you invested $1,250 over five months using a dollar cost averaging approach. At the end of month five, you own 67 shares, and have paid an average of $17.80 per share. If you had invested a lump sum of $1,250 in month one, you would have paid $20 per share and own just 62 of the same shares. In this example, by using the dollar cost averaging approach, you have come out ahead.
Of course, this doesn’t always happen. In the example above, if the share price were to continually rise after month one, then you would own less shares at the end of the 5-month period, having paid a higher price per share.
Things to bear in mind
While dollar cost averaging can help protect you from market fluctuations and minimise market timing risk, investing regularly in a share or fund that continues to fall, and has poor prospects for future income or growth, can be unwise.
Something else to bear in mind is that dollar cost averaging, in isolation of an initial lump sum investment, can mean delaying the rest of the money you potentially have to invest, and therefore its exposure to the markets. Of course, if you don’t have a larger lump sum of money lying around ready to invest, this may not really be a trade-off for you. What’s important is that you’re continuing to invest where you can.
There is, of course, also the risk that any money you don’t invest at the outset, is spent or re-directed elsewhere. To keep the momentum going, you really need to be diligent and consider prioritising your investing as a non-negotiable item in your budget.
As always, whether the dollar cost averaging approach makes sense for you really depends on your own personal circumstances, including your risk tolerance and capacity, and the amount of spare cash you have at your disposal. If investing a lump sum of money fills you with fear, or you simply don’t have it, then dollar cost averaging might be something to consider. Investing some money may be better than not investing at all.
Before you make any decisions, consider seeking financial advice.