When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
What is dollar cost averaging?
Dollar cost averaging is a proven way to take advantage of long-term investment opportunities while removing tough decisions about timing buy and sell orders.
Focusing your efforts on investing consistently over time yields better results than trying to time your investments perfectly.
Focusing your efforts on investing consistently over time yields better results than trying to time your investments perfectly.
QUOTE
"If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar cost average into index funds."
Big Ideas
- Dollar cost averaging is a way to spread your stock purchases over time, reducing the risk of bad timing.
- Dollar cost averaging works well as part of a long-term investment strategy.
- With the benefit of hindsight, dollar cost-averaging in S&P 500 funds during the ‘great recession’ of 2008 was a shrewd investment strategy.
What does dollar cost averaging mean?
Dollar cost averaging (DCA), or as it is sometimes called, the constant dollar plan, means consistently investing a certain amount of money in a particular security over time. The investing pattern should be followed regardless of what’s happening in the markets.
This strategy helps reduce your average buying price during a down market and gives you a cushion against market volatility. You will be spending small amounts of money over time, which means you’ll be buying stocks when the prices are low and also when they are high. This ultimately averages out the price of stocks over time.
Another benefit of dollar cost averaging is that you don't have to invest so much of your time and effort keeping tabs on the markets. Since you will follow a regular investing pattern, you should be oblivious to the continuous market ups and downs.
Investment and retirement accounts like ISAs in the UK or IRAs and 401(k) in the USA are common vehicles for implementing dollar-cost averaging strategies.
This strategy helps reduce your average buying price during a down market and gives you a cushion against market volatility. You will be spending small amounts of money over time, which means you’ll be buying stocks when the prices are low and also when they are high. This ultimately averages out the price of stocks over time.
Another benefit of dollar cost averaging is that you don't have to invest so much of your time and effort keeping tabs on the markets. Since you will follow a regular investing pattern, you should be oblivious to the continuous market ups and downs.
Investment and retirement accounts like ISAs in the UK or IRAs and 401(k) in the USA are common vehicles for implementing dollar-cost averaging strategies.
What is dollar cost averaging in practice?
Dollar cost averaging
For instance, if you earn £2,000 monthly and allocate £200 of the salary to your pension plan. Out of the £200, you could opt to invest £100 in an S&P 500 index fund and £100 in another mutual fund.
Every month, £200 will be deducted from your salary and invested in the two funds, no matter the price. You will invest during the market highs and lows over the year; hence, the term ‘dollar cost averaging,’ i.e. the prices you paid average out over time.
Every month, £200 will be deducted from your salary and invested in the two funds, no matter the price. You will invest during the market highs and lows over the year; hence, the term ‘dollar cost averaging,’ i.e. the prices you paid average out over time.
Dollar cost averaging vs lump sum investments
A big question many investors face when they have built up a ‘war chest’ of funds to invest is whether to opt for dollar cost averaging or make a lump sum investment. To think this through, consider these three aspects:
- Your risk tolerance
- Your ability to stay consistent and stick to your investing plan
- How long can you hold on to the investment (investment horizon)
Lump-sum investing is about investing the entire investment or all your investable funds at once. Usually, people invest a lump sum if they receive a windfall from inheritance or the sale of another asset or when they judge that the market is about to hit a low.
To clarify, the lump sum needn’t be invested into just one stock or one asset. You can add to pension funds or diversify your stock portfolio by investing in different stocks or index funds. This will act to minimise risks from relying on only one investment.
Both lump sum investments and dollar cost averaging are effective for investing money, so the choice between them is your own.
To clarify, the lump sum needn’t be invested into just one stock or one asset. You can add to pension funds or diversify your stock portfolio by investing in different stocks or index funds. This will act to minimise risks from relying on only one investment.
Both lump sum investments and dollar cost averaging are effective for investing money, so the choice between them is your own.
If you have a low-risk tolerance, dollar cost averaging is probably the right strategy for you. It will help spread your investment amount over time. However, if you are more tolerant of risk, perhaps because you are just beginning your career, lump sum investing offers the chance of higher returns within the same period, but with higher risk.
The benefits of lump sum investing are as follows:
- A study conducted by Williams and Bacon showed lump sum investing yields higher returns than dollar cost averaging about two-thirds of the time.
- Investing the whole amount rather than keeping cash in hand offers greater market exposure, including exposure to greater gains and losses.
Lump sum investing has a few drawbacks as well:
- Market fluctuations can be unpredictable, so the investment carries high risk.
- If you are not risk averse, you may get emotionally invested in watching your investment, possibly leading to poor decisions.
- Lump sum investing is not a consistent strategy for the long run.
Verdict: Dollar Cost Averaging Vs. Lump Sum
Lump sum investment can yield higher returns, so if your main objective is to enhance the performance of your investment, go for it.
If you are not very risk-tolerant, dollar cost averaging might be more suitable because you slowly increase the risk over time, putting less at stake at the beginning.
If you are not very risk-tolerant, dollar cost averaging might be more suitable because you slowly increase the risk over time, putting less at stake at the beginning.
LSI vs DCA: Investing just before the financial crisis
Source: MorningStar. Past performance doesn’t guarantee future results.As you gain experience and can better handle risk, you can invest more at specific times rather than spreading the investments throughout the year.
The most important thing is to devise a plan of action. Set realistic goals and be mindful of the risk exposure you are willing to take on your investment.
The most important thing is to devise a plan of action. Set realistic goals and be mindful of the risk exposure you are willing to take on your investment.
Dollar cost averaging benefits
A dollar cost averaging strategy is easy to start and understand and can be followed by novices as well as pros. Here are a few main benefits of the strategy.
✔️ Not timing the market
With dollar cost averaging, you don't have to invest efforts to time the market. Since the markets are often unpredictable, DCA keeps you safe from mistiming the market and making the wrong calculations or investment decisions.
✔️ Fewer emotions
Your emotions and psychological biases stay out of your investing decisions in dollar cost averaging. Often people fear losses due to market lows and make the wrong decisions. DCA, while being consistent, keeps you free from such worries.
✔️ Long-term gains
The market usually follows an upward trend over time. So if you keep investing, you will see that even market crashes can be great opportunities over the long term. Your investment won’t result in a loss but would only yield higher over the years.
✔️ It's automatic
It's an automatic mode of investment. You don't have to wait for the market to fall or think about when to invest.
✔️ Healthy investment practice
DCA is about investing regularly, slowly building wealth over time while minimising risk.
Pros of dollar cost averaging:
➕ DCA minimises risk by spreading the investment over time in portions.
➕ You don't have to time risks and the market.
➕ Following DCA makes you avoid impulsive and rash investing decisions.
Cons of dollar cost averaging:
➖ Not investing during opportunistic times can translate to limiting your gains.
➖ You must stick to the DCA plan, which requires resisting the urge to time the market and getting tempted to invest during the market lows.
➕ DCA minimises risk by spreading the investment over time in portions.
➕ You don't have to time risks and the market.
➕ Following DCA makes you avoid impulsive and rash investing decisions.
Cons of dollar cost averaging:
➖ Not investing during opportunistic times can translate to limiting your gains.
➖ You must stick to the DCA plan, which requires resisting the urge to time the market and getting tempted to invest during the market lows.
Dollar cost averaging frequency
Different investors follow different frequencies for their dollar cost average strategy. It can be as often as a daily practice for some; others may opt for weekly, monthly, semi-annual, or annual investments.
1. Daily dollar cost averaging
Since you will invest every day, every spike in the price, either up or down, could be captured. This means many dips can be bought, but on the other hand, you would also be buying on the rallies.
Moreover, the strategy also keeps you updated and in the know about developments in market prices.
Looking further out, your investments made over time (during the highs and lows) would eventually average out like any DCA plan.
Moreover, the strategy also keeps you updated and in the know about developments in market prices.
Looking further out, your investments made over time (during the highs and lows) would eventually average out like any DCA plan.
2. Weekly dollar cost averaging
Depending on your ability to invest or how and when you get your salary, you can opt for the weekly plan.
When considering a weekly DCA vs monthly DCA, one consideration is the cost of transferring money. Fortunately, with Trading 212, bank transfers are normally free, but funding your account by credit card can incur fees.
When considering a weekly DCA vs monthly DCA, one consideration is the cost of transferring money. Fortunately, with Trading 212, bank transfers are normally free, but funding your account by credit card can incur fees.
3. Monthly dollar cost averaging
Most investors prefer the monthly dollar cost averaging method. This is a more familiar frequency to those used to a SIPP plan where funds are taken directly from your salary and invested into your investment account. A monthly DCA plan suits those who prefer a more laissez-faire approach - you can just invest once every month without keeping tabs on the market or volatility.
If you get your salary once a month, you can tie the investment amount with the salary and let it be deducted automatically from your bank account.
The main drawback is that you may miss some market opportunities during the daily slumps, which average out by the time your monthly deposit is made.
So there are different dollar cost-averaging frequencies. You can decide which works best for you over the long term.
If you get your salary once a month, you can tie the investment amount with the salary and let it be deducted automatically from your bank account.
The main drawback is that you may miss some market opportunities during the daily slumps, which average out by the time your monthly deposit is made.
So there are different dollar cost-averaging frequencies. You can decide which works best for you over the long term.
Dollar cost averaging formula
There is no particular need to remember a dollar cost averaging formula because the idea is easy to grasp.
However, using the following method is useful to keep track of your average buying price - something that is much easier to record if making less frequent investments.
However, using the following method is useful to keep track of your average buying price - something that is much easier to record if making less frequent investments.
DOLLAR COST AVERAGING FORMULA
Average Buying Price = Amount Invested / Number of Shares Owned
Dollar cost averaging S&P 500 ETFs
The S&P 500 index is one of the simplest and most diverse places to employ a dollar cost averaging strategy. You can pick your favourite S&P 500 index fund or ETF to invest in at the same time every month.
Investing at the index level rather than picking stocks means not only are you removing the decision over timing but also largely removing the decision over which stocks to include in your portfolio.
Investing at the index level rather than picking stocks means not only are you removing the decision over timing but also largely removing the decision over which stocks to include in your portfolio.
Chart: 100-year history of the Dow Jones
Past performance doesn’t guarantee future results.
Even for those who like to pick stocks, simultaneously dollar cost averaging into index ETFs like the S&P 500, FTSE 100 or DAX 40 adds some diversity to the way you go about achieving your long-term financial goals.
Even for those who like to pick stocks, simultaneously dollar cost averaging into index ETFs like the S&P 500, FTSE 100 or DAX 40 adds some diversity to the way you go about achieving your long-term financial goals.
Keep dollar cost averaging in a bear market
Investing during bear markets is tricky. Even if you have opted for the dollar cost-averaging method, investing during dips can be stressful. Naturally, in a market that historically rose over time, the best time to do dollar cost averaging is in a bear market when prices are lower to lower your averaging buying price.
In short, bear market DCA allows you to buy more low-priced shares before the market climbs again.
Be careful, though. Novice investors often assume that when the market goes up, all the individual stocks that fell will go up just as much. But many of the stocks that dropped in a bear market never recover and get replaced by other successful companies.
One way to overcome this is, instead of focusing on individual stocks, to concentrate on the broad market index. More importantly, even when dollar cost averaging is important, it is important to review the companies you own periodically and make sure it still makes sense to own them.
In short, bear market DCA allows you to buy more low-priced shares before the market climbs again.
Be careful, though. Novice investors often assume that when the market goes up, all the individual stocks that fell will go up just as much. But many of the stocks that dropped in a bear market never recover and get replaced by other successful companies.
One way to overcome this is, instead of focusing on individual stocks, to concentrate on the broad market index. More importantly, even when dollar cost averaging is important, it is important to review the companies you own periodically and make sure it still makes sense to own them.
Recap
Dollar cost averaging is one of the most trusted investing strategies because it is easy to follow, doesn't involve timing the market, and is a proven way to achieve long-term gains. Buying on a regular basis spreads out the risk of stock market investing but tends to underperform strategies with large exposure to the market, such as lump sum investing.
FAQs
Q: What is dollar cost averaging in investing?
Dollar-cost averaging is the practice of regularly investing a fixed amount of money over time without considering the share price or market situation. It is a simple but disciplined approach to investing, free from psychological bias and stress.
Q: How dollar cost averaging works?
Dollar cost averaging means investing a certain amount in the same stock or ETF consistently. You may invest the amount weekly, monthly or annually; the key is persistence, no matter the market fluctuations.
Q: How much should I dollar cost average?
Dollar-cost averaging depends on two main factors, the amount you wish to invest and regularly investing the same amount.
You need to determine first the total amount you will be spending. For example, if you are investing $100 every month, you need to make sure you can invest the same every month for 10-20 years, through thick and thin. Consider your risk tolerance and how much you can consistently spend in the long run to decide how much to invest in dollar cost averaging.
You need to determine first the total amount you will be spending. For example, if you are investing $100 every month, you need to make sure you can invest the same every month for 10-20 years, through thick and thin. Consider your risk tolerance and how much you can consistently spend in the long run to decide how much to invest in dollar cost averaging.
Q: How long to dollar cost average?
Whatever amount you are thinking of investing, you need to plan out how to invest it and follow the plan strictly. Dollar-cost averaging is a good plan for long-term investments because it is easier than other methods to do consistently. Consider investing in a consistent pattern for 10 to 20 years for the best outcomes.
Q: Why is dollar cost averaging good?
Dollar-cost averaging reduces investment risk. It is an effective strategy to keep your capital safe from market volatility. It also gives you more liquidity and freedom to invest and widen your portfolio.
DCA also keeps you in the market, whether high or low. During down periods in the market, your purchase price reduces, and you get to buy more shares when the price is low, then when there is an up market, you have the opportunity to sell.
DCA also keeps you in the market, whether high or low. During down periods in the market, your purchase price reduces, and you get to buy more shares when the price is low, then when there is an up market, you have the opportunity to sell.
Q: Who Invented dollar cost averaging?
The term dollar cost averaging was first coined by Benjamin Graham in his book "The Intelligent Investor".
- Volatility: A measure of how much the price of an asset fluctuates over time.
- Lump Sum Investing: A strategy where an investor puts a large amount of money into investments all at once, rather than spreading it out over time.
- Index Fund: A type of mutual fund or exchange-traded fund (ETF) designed to track the performance of a specific market index, such as the S&P 500.
- Bear Market: A market condition where stock prices are falling, usually by 20% or more, often accompanied by economic downturns and pessimism.
