What is Dollar Cost Averaging?
When it comes to investing in the share market, or any market for that matter, timing when to buy in and sell out of an investment becomes an important decision. One way of lessening the impact of these decisions is to invest regularly. This is because by sticking to a regular savings plan, you will actually be using the ups and downs of the market to your advantage. This phenomena is known as 'Dollar Cost Averaging (DCA)'.
How Does Dollar Cost Averaging Work?
Dollar cost averaging involves buying assets at different prices by making regular deposits. As a result, you purchase more units when prices are low and fewer when prices are high, but the cost of investing averages out over time.
In turn, it becomes less important for you to choose the right time to make your investments. This is because by consistently depositing small amounts of money, you will reduce your vulnerability to unit price fluctuations and free yourself of the worry of trying to guess the best time to invest.
Dollar cost averaging example chart
Here is an example of dollar cost averaging. The example is for a fictitious managed fund we call Managed Fund ABC. The minimum investment for Managed Fund ABC is $6,000. Many people don't have $6,000 to pay upfront but the fund allows investors to go on a savings plan.
| Investment date | Amount Invested | Price per share | # Shares purchased |
|---|---|---|---|
January | $500 | 36.855 | 13.57 |
February | $500 | 36.325 | 13.76 |
March | $500 | 35.795 | 13.97 |
April | $500 | 35.300 | 14.16 |
May | $500 | 35.22 | 14.16 |
June | $500 | 34.833 | 14.35 |
July | $500 | 35.123 | 14.24 |
August | $500 | 35.212 | 14.20 |
September | $500 | 35.157 | 14.22 |
October | $500 | 35.765 | 13.98 |
November | $500 | 36.48 | 13.71 |
December | $500 | 37.478 | 13.34 |
Total | $6,000 | 35.795 avg | 167.47 |
The above chart is the result of dollar cost averaging over a 12 months period. What you can see is that when prices are high fewer shares are purchased and when prices are low more are purchased. The average unit price comes to $35.795, which is lower than the price during January, $36.855. The total units bought is 167.47 units which is more than the 162.8 units had you bought at Januarys prices.
In this example we see the benefits of dollar cost averaging as you end up paying less for the units overall, however this is not always the case and the opposite can easily happen.
Lump sum investing VS Dollar cost averaging
Lump sum investing (LSI) is when you invest all your money in one go. The question then is, suppose you inherited $50,000, should you invest the total amount in one go or should you use the dollar cost averaging technique? This issue has remained a subject of heated debate, opponents of DCA argues that research has shown that markets will rise two-thirds of the time and thus money in the market as appose to 'waiting' is almost always better off. They say dollar cost averaging is a myth and that it's a salesman's tool to prize away your money in small increments.
Whether or not one is better than the other, if you feel that dollar cost averaging is the "safer" option and it leads you to starting to invest rather than leaving your money in a bank, then it can only be a good thing.
The Benefits of a Regular Savings Plan
A regular savings plan is a very effective way of adding to your savings and building them up over time. It is a way for those without existing cash reserves to start up the process of wealth creation, without sacrificing their present lifestyle.
As part of a regular savings plan, 'Dollar Cost Averaging' is a tool that investors use to create wealth and reduce risk. By outlaying only small amounts of capital at any time, the investor's exposure to the fluctuating market is limited, yet the advantages of an ever-growing asset base are returned.