Dollar Cost Averaging

Although the term might initially imply a complex mathematical concept, Dollar Cost Averaging is actually a fairly simple technique that can be used by all share investors. Dollar cost averaging is the process of buying, regardless of the share price, a fixed dollar amount of a particular investment on a regular schedule. It's a strategy that is also called the constant-dollar plan. More shares are purchased when prices are low, and fewer shares are purchased when prices are high. The cost per share over time will eventually average out. This reduces the risk of investing a large amount in a single investment at the wrong time. But beware, dollar cost averaging has its drawbacks.

Let's look at dollar cost averaging with an example.

dollar chart

You have just had a windfall of $20,000 and wish to increase your share portfolio and invest it all in a particular share or managed fund. Instead of investing the lump sum into a stock or managed fund, with dollar cost averaging you'd spread the investment out over several months. For example, investing $2,000 a month for the next ten month’s, "averages" the price over ten months. So one month you might buy in at a high price high whereas the next month you might be able to buy more shares because the share price is lower. It is also argued that this type of investing is also applicable to the investor who doesn't have that big lump sum at the start, but can invest small amounts regularly. This way you can contribute as little as $25-50 a month to a share investment like an index fund. This spreads the cost basis out over several years, providing a certain insulation against changes in market price.

There is a drawback………………

Amongst the general public, dollar cost averaging appears to go against all we have been told about prudent investing. Economists have shunned dollar cost averaging and have been able to demonstrate its irrationality and inefficiency, in nearly all studies Dollar cost averaging does not outperform lump sum investing. Suffice to say, the vast amount of financial planners and mutual funds love dollar cost averaging as it makes the investor contribute regularly and takes away the emotion and uncertainty of timing the market. But they either don't have the foggiest to what is really going on (probably 90%+) or are just playing the emotional element of investing.
More importantly, dollar cost averaging doesn't prevent losses in a declining market. Is Dollar Cost Averaging for anyone? well, as we have stated, if you do not have a clue what you are doing and find that you are too emotional about investing in the stockmarket, it is a less stressful method.