Dollar Cost Averaging: Explained
In a nutshell:
Dollar cost averaging is where you invest your money at set intervals over a period. Advantages include; taking the emotion out of investing, no market timing issues, and we are able to ‘set it and forget it’. However, the main drawback is that lump sum investing beats dollar cost averaging, in terms of returns, 66% of the time.
- Dollar cost averaging can be referred to as DCA, or ‘pound cost averaging’ in the UK
- By dollar cost averaging we achieve a lower ‘cost basis’
- Takes the emotion out of investment
- Good for risk-averse individuals
- No market timing problems
- However, lump sum investing beats DCAing 66% of the time.
- Dollar Cost Averaging
- Dollar Cost Averaging Example
- Emotionless Investing
- Set it and Forget it
- All-round Strategy
- Final Word
Dollar Cost Averaging
Firstly, what is dollar cost averaging?
Sometimes referred to as ‘DCA’ or ‘DCAing’, dollar cost averaging is simply where you invest at regular intervals over a period, such as over the course of a year.
The main benefit is that over the long-term, as there are booms and recessions, and the stock market goes up and down, we are able to achieve a lower ‘cost basis’. Essentially, this means the price we pay is cheaper over the long-term.
Whilst there are a number of reasons why you should invest, dollar cost averaging is simply one way or ‘strategy’ to invest your money into the stock market.
Dollar Cost Averaging Example
We choose to ‘DCA’ into Company X by making a £100 purchase each month. But, the stock price of Company X changes each month because the stock market is volatile, meaning some months we get more stocks of Company X with that £100, and other months we get less stocks of Company X.
First month: £20 – buy 5 stocks
Second month: £10 – buy 10 stocks
Third month: £12 – buy 8 stocks (8.3 to be exact, with fractional shares)
Fourth month: £20 – buy 5 stocks
Fifth month: £25 – buy 4 stocks
Lower Cost Basis
After Month 5, we have spent a total of £500 and in return bought 32 stocks of Company X. Now, lets work out our cost basis:
£500 divided by 32, £500/32, gives us £15.63.
Therefore, even though the current stock price for Company X is £25, our ‘cost basis’ is lower, at £16-odd. This is because we have ‘averaged down’ by buying Company X on the way down, and continued buying all the way back up, giving us a lower stock price than the current market price!
At the current market price of £25, our 32 stocks are worth £800.
Now we know how it works, let look at some advantages for dollar cost averaging…
Firstly, the main pro is that by setting up a regular investment, we suggest every month; we are able to take the emotion out of investing.
Humans are irrational, typically buying stock on the way up – when it’s the wrong time to buy, and selling on the way down – when it’s the perfect time to buy. This is why average ‘retail’ investors like you and me lose money in the market!
However, by setting up a recurring monthly payment, we are able to invest automatically, without even considering what the market is doing day-to-day. We would suggest not even looking at your %-return, especially not day-to-day, but make sure you evaluate your investments at least twice a year.
Secondly, DCAing is less risky than lump sum investing. If you invested £1k today and the market crashes tomorrow (note: no one can predict when the market will crash, period) then it may take 5+ years to recover this £1k and breakeven, depending on how severe the crash is.
Essentially, it helps us to avoid problems of market timing. We don’t have to look at any charts or complicated financial ‘stuff’. Market timing is such a huge debate, but it is impossible to time the market with any reliability and consistency, so dollar cost averaging helps gets rid of all market timing problems!
Therefore, if you are a particularly risk-averse person, then dollar cost averaging would be a lot better for your stomach than lump sum investing!
Set it and Forget it
Thirdly, one of the great things about using dollar cost averaging is that you can ‘set it and forget it’:
- Open up a brokerage account
- Choose a index fund, for example
- Set up a recurring payment, £100 every month, for example
- Don’t do anything for 30 years
By this we mean that you are able to open an account, put in your card details, and then money will automatically be taken out and invested into the stock market on a set date each month. You will never have to look at your brokerage account again (hypothetically, it’s still good to assess your investments at least twice a year!).
Particularly if you invest in an index fund, such as a global index fund, you won’t have to do any individual stock research or anything – just let time and the stock market do its thing.
Investing for the long-term is the way to go when investing. With compound interest and time on our side, we can build some serious wealth!
Lastly, and in summary, dollar cost averaging is an all-round good strategy. Helping to avoid market timing issues, good for people who don’t like to lump sum invest and take on more risk, and takes the emotion out of investing.
Let’s be honest a lot people have little to no interest with the world of finance. However, the fact is without investing of some sort (stock market, real estate, own business, and so on), then we will never become wealthy – we have to invest to achieve financial freedom!
This strategy takes little to no effort and little to no knowledge, but can help the average investor build huge sums of wealth over the years.
Nevertheless, with anything, there are some drawbacks to dollar cost averaging.
Lump sum Investing
The most significant drawback is that lump sum investing beats dollar cost averaging most of the time. A study from Vanguard has revealed that lump sum investing, where you invest all your money at once rather than dollar cost averaging over a period, beats dollar cost averaging roughly 66% of the time.
Therefore, according to this research, in terms of achieving a higher return, then it is better to lump sum invest. Although, lump investing also has it lists of pros and cons, with a con being that it is more risky.
Another drawback we wanted to mention is that, depending on your broker, they may charge you a ‘transaction fee’ each month when you invest using dollar cost averaging. So make sure there is no fee, or the fee is very small!
We personally dollar cost average into a global index fund, from Vanguard, each and every month. We are investing for the long term, and the market goes up more than it goes down, so we see it as a good strategy for the average investor. Of course, do your own research before deciding whether DCAing is for you!
This is everything about dollar cost averaging.