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Dollar Cost Averaging

Investment

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5.5.22 |

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A simple yet powerful investment strategy

Ideally, investors would buy assets at a low price, then sell at a high price. This is great in theory.

Though over timeframes of less than a few years, investors trying to "time the market" by buying stocks (shares) or other assets at their absolute lows and selling at peak highs is a fool's errand, study after study has refuted this investment approach. Even professional traders struggle to consistently buy at a good time, let alone sell again. Instead of agonising over when to buy and sell, many investors (both new and established) turn to a deceptively simple yet powerful investment approach called dollar cost averaging (DCA).

What Is Dollar Cost Averaging?

DCA might sound complicated, though in fact is simple. DCA is an investing strategy where you invest a fixed amount of money regularly, regardless of what market prices are doing. Instead of trying to pick the perfect moment to invest a lump sum, you spread out your investment over weeks, months or even years by making smaller, regular investments.

You only have to look at world events to see why this might be a good idea. How can you (or anyone!) ever pick the right investments when war, pandemics, and natural disasters can all mess up markets without warning?

The key advantage of DCA is that it removes emotion and guesswork from investing. Legendary investor Benjamin Graham first coined the term in his book, The Intelligent Investor, published in 1949. Graham put it like this:

"Dollar cost averaging means simply that the practitioner invests the same number of dollars each month or quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings."

For instance, you might invest $100 every week into a fund tracking the NZX50. Some weeks your $100 will get more shares when prices are down, while in other weeks it will buy fewer shares when prices are up. Over time, this systematic approach smooths out the price fluctuations to a happy medium.

Dollar Cost Averaging in Action

Let's look at a hypothetical example to see how DCA works in practice:

Imagine you have $10,000 to invest. Do you want to invest it all at once or use DCA? The bullet points below show an example. It shows the price of shares in a fictitious company over five months and how many shares you would get if you bought $2,000 worth of shares every month.

January, share price $24 so $2,000 worth of shares equals 83 shares
February, share price $12 so $2,000 worth of shares equals 167
March, share price $10 so $2,000 worth of shares equals 200
April, share price $17 so $2,000 worth of shares equals 118
May, share price $15 so $2,000 worth of shares equals 133
In total, you’d have 701 shares

One Big Bet or Spread the Risk?

But what if you invested the whole $10,000 in one big bet? Let's first imagine the worst-case scenario. If you bought shares in January at $24, you would get 417 shares. But in the best-case scenario if you bought shares in March at $10 you would get 1,000 shares!

Now let’s imagine you use DCA to spread the risk. If you bought $2,000 worth of shares every month, you’ll buy when shares are at their lowest and highest. As the example above shows, if you bought in January, February, March, April, and May, you’ll have a total of 701 shares.

Investing with DCA you’ll have bought shares at what Graham called a “satisfactory overall price” without any thinking involved. Of course, this is just a hypothetical example. Let’s look at the pros and cons.

Dollar Cost Averaging Advantages

For most individual investors, here are the key advantages of DCA:

Confidence: Investing often gives you confidence you’ll get a decent price over time. This can help overcome the fear of investing, and wondering if the market will go up or down. By spreading investments over time, you avoid excessive risk from poor timing.
Set and forget: DCA takes the emotion and guesswork out of investing. You don’t have to watch the markets like a hawk, stressing over the highs and lows. Instead, you can focus on your career, family, or hobbies and still invest in shares or funds. Your contributions can be made by automatic payment or direct debit.
Long-term thinking: Automating investments at a set dollar amount makes it easier to stick to your plan through up and down markets. By its nature, DCA is a long-term approach, so you will be more inclined to stick to it.
Good for your wallet: It benefits from lower costs over time. You'll buy more shares when prices are lower and fewer when prices are higher, lowering your average cost per share.
You can start now: It allows you to invest smaller amounts. Don't have $12,000 to invest all at once? With DCA, you can start with just a few dollars.

Learn more:

Dollar Cost Averaging Disadvantages

While DCA offers some nice benefits, it isn't a perfect strategy.

Before you start investing in stocks or funds you might be better off investing in your own skills or earning power, repay bad debts, accumulate a deposit to buy your own home or repay a mortgage, or even invest in property. That’s why, before investing it’s good to work through a wealth building checklist.

Moving on, here are a few potential downsides of DCA:

Limited returns: Investing with the DCA method probably means you’ll minimise both risk and reward. For instance, if a share or sector of the market is undervalued, investing a sizeable sum all at once could be more lucrative than investing over time.
Underperform on a rising market: In the same way, if the share market is booming, you’ll likely underperform. You will still make a return, but as the price of shares rises, your fixed amount of money will buy fewer shares.
Complexity for a sizeable sum. If you’re investing a one-off sum and use DCA to do it by spreading the investment out across several small payments in different weeks, months, quarters (quarters of a year, three months), or even across several years, it just adds complexity and makes it more likely you’ll change your mind before you’ve invested it all, lose your nerve, or at least second-guess your own choices.

Two Groups That Should Use Dollar Cost Averaging

DCA is a popular method of investing with everyone from established to everyday investors. Warren Buffet, the world’s most famous investor, is an advocate of DCA for most investors. He argues if you’re not spending hours researching companies, then use DCA. He said:

"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."

With that in mind, here are two groups of investors that should use DCA:

New Investors:

If you're just starting out and don't have a sizeable sum to invest, DCA allows you to put a little money to work consistently over time as you save more. Nearly all investing apps, managed funds, ETFs, and stockbrokers make it easy to automate small, regular investments.

Retirement Investors:

If you have a KiwiSaver or other superannuation fund where you make automatic contributions from each pay, congratulations - you're already using DCA!

For these investors, trying to make large one-time investments may not be sensible, or through payroll is impractical. DCA represents an affordable path forward when you're investing modest sums consistently.

The Bottom Line: Invest the Easy Way with DCA

DCA is a great way to start investing. It offers behavioural advantages that can help investors navigate volatile markets more comfortably and with little effort. It enforces disciplined investing habits, allows you to start small, and can make it easier to stick with your plan during downturns.

So, while market timing and lump sum investing may produce higher theoretical returns, consistently executing those approaches is far easier said than done. For most long-term investors, DCA is a powerful and psychologically safer way to build wealth over time.

Interested in building wealth? It’d be the pleasure of one of our trained professionals to help you work through any of the topics mentioned above, so get in touch today.