Dollar cost averaging is a strategy in which investment positions are built by investing equal sums of money at regular intervals, regardless of the asset’s price or what is going on in the financial markets. In the UK, this strategy is referred to as pound cost averaging. These regular investments can be in terms of a fixed amount of currency or a fixed number of shares. The intervals can be weekly, monthly, yearly or whenever suits an individual’s investment plan the best.
The idea behind this strategy is that when prices are high, you can only afford a certain number of shares. When prices drop, you can purchase more shares with the fixed amount you are investing in each period. Then, when the market recovers, you benefit from having more shares when you bought them at a low price.
To get a better understanding of how dollar cost averaging works, we will work through a hypothetical example. Say that you invest $100 per month into an index fund for five months. As share prices vary at each interval, you receive a different amount of shares each time when you invest $100, as illustrated below:
| Month | Investment | Share price ($) | Units purchased | Shares total | Total value |
|---|---|---|---|---|---|
| 1 | $100 | 5 | 20 | 20 | $100 |
| 2 | $100 | 3 | 33 | 53 | $159 |
| 3 | $100 | 2 | 50 | 103 | $206 |
| 4 | $100 | 6 | 17 | 120 | $720 |
| 5 | $100 | 6.5 | 15 | 135 | $878 |
| Total amount invested= | Average share price= | Total units purchased= | Investment value | P/L | |
| $500 | $4.50 | 135 | $878 | $378 |
Note: numbers are rounded
After making monthly contributions of equal amounts, your total investment after five months is $500. With 135 shares at the end of the period, the investment value is $878. Therefore, you would have profited $378.
It is important to highlight the average price per share compared to the average price per share you end up paying. In this case, the average share price at the end of the five months was $4.50 ((5+3+2+6+6.5)/5)). However, the average price you paid per share was significantly lower at $3.70 ($500/135 shares).
Of course, it is not to say that utilising this strategy will always result in a profit nor it is to say that it will protect investors from falling share prices.
Dollar cost averaging vs. timing the market
An opposing strategy to dollar cost averaging is to time the market. Timing the market is an investment strategy whereby investors attempt to beat the stock market by predicting its performance. It is an active strategy that focuses on the short term and requires close attention and monitoring of the market. Some investors choose this approach because if they get their timing right, they can generate above-average returns. However, perfectly predicting the markets continuously is impossible.
Dollar cost averaging, on the other hand, is a passive investment strategy. This strategy does not require as much attention to the market, as you make investments of the same amount of money on a regular basis. Also, rather than entering and exiting different positions, you build a position in a stock, bond or fund.
Advantages of dollar cost averaging
A dollar cost averaging benefit is that it takes emotional factors out of investing. Since you are regularly making investments no matter what the market conditions are, emotions are eliminated out of the decision-making process. For example, if the market is on a downswing, some investors might panic and sell off their holdings. With this approach, it can be seen as an opportunity to buy at low prices, keeping in mind that this strategy is typically used for long term investment horizons.
As demonstrated in the above example, this investment strategy can also help to average out share price fluctuations and reduce the price you pay per share. Since you buy more shares when prices are low, this generally creates a scenario where the average cost per share you pay is lower than the average share price.
Additionally, this strategy enables investors who do not have a large lump sum of money to build a position in a certain product over time. For example, some investors might have $10,000 to invest at once. Whereas, other individuals might not have such a sum at a certain time, but can use this strategy to build up to a position worth $10,000.
Disadvantages of dollar cost averaging
Like any other investment strategy, dollar cost averaging has its drawbacks. For one, some experts say that making use of this strategy can have lower returns in comparison to a lump sum investment. The argument here is that stock markets tend to rise over time and, therefore, leaving money out of the market can miss out on big gains.
Another potential disadvantage of this method is more fees. If you are investing with a broker, you typically have to pay brokerage fees for the transactions that you make. Therefore, if you are investing at regular intervals versus one lump sum, you may end up paying more fees.
Risks involved
Choosing to use a dollar cost strategy can be rewarding, but it is not without risk. At DEGIRO we are open and transparent about the risks that come with investing. Before you start to invest, there are a number of factors to consider. It helps to think about how much risk you are willing to take and which products match your knowledge. Additionally, it is not advisable to invest using money that you may need in the short term or to enter into positions that could cause financial difficulties. It all starts with thinking about what kind of investor you want to be. You can read more about the risks of investing on our dedicated risk page.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
