DOLLAR COST
AVERAGING

Dollar cost averaging involves investing fixed amounts regularly, regardless of market conditions. This method averages purchase prices over time, promoting discipline and a long-term approach. This article will explore how investors can use the dollar cost averaging strategy in various market conditions.

Historical data shows that gaining exposure to different instruments such as stocks can generate long-term returns, but with financial markets being inherently unpredictable, there is a constant question about how and when to invest.

The dollar cost averaging strategy has been developed to resolve that question. It can take some of the emotion and work out of the decision-making process and allow you to successfully navigate the inevitable peaks and troughs in a market.

Understanding dollar cost averaging

Dollar cost averaging is an investment technique that focuses specifically on the way that your capital is invested in the financial markets. The approach can be applied to any asset type and involves drip-feeding your cash into the markets rather than investing one lump sum at any one point in time.

The mechanism and its advantages

The approach involves investing fixed and predetermined amounts of cash into investments on a regular basis,  which averages out the cost of investment. For example, investing $200 per month in the same equity, then, some months you will buy more or less of the same stock due to the price of the instrument fluctuating over time.

Averaging into positions brings a greater amount of discipline into your investment strategy and helps you to adopt a long-term approach that rides out the spikes in price volatility. The process can also be automated to some extent, saving time and making investing a relatively low-maintenance task.

There is room for the amount invested to be adjusted over time. If the current price of an asset is lower than the average price of your position, and you have been purchasing for some time, the asset may be considered undervalued on a long-term basis. 

Scaling up or down on the size of your regular investment is not necessarily “good” or “bad” and allows investors to apply some degree of influence on the strategy. It does, however, diminish one of the key advantages of dollar cost averaging — that making a call on the market can be challenging and that an averaging approach removes the risk of making decisions you may later regret. 

Dollar cost averaging vs lump-sum investing

There is no guarantee that using the dollar cost averaging technique will result in the average price at which you buy assets being lower than if you adopt a lump-sum approach. A lump-sum investor could, after all, buy at the bottom of a market dip and achieve a very attractive entry price. 

The advantages of dollar cost averaging extend past the other possible scenario that the lump-sum investor faces — that they invest all their cash at the top of the market. The dollar cost approach enables investors to gain exposure at an average level and breaks down the challenge of inertia resulting in investments not being made at all — all of which is done by following some simple guidelines.

Implementing dollar cost averaging

Time-poor investors will note that one of the advantages of an averaging approach is that most of the strategy planning is done before you start investing. It is important to monitor positions on an ongoing basis, but dollar cost techniques are relatively easy to implement. 

Practical steps and considerations

The first part of the process involves establishing your own personal set of investment aims and investment skillset. It is also worth remembering that while dollar cost averaging can neutralise some of the effects of market volatility, the amount of cash you are able to invest is also subject to change.

Life events such as births and deaths can impact the amount of capital you are willing to allocate, and without built-in tolerances, this would result in your average price strategy becoming skewed.

Choosing the right interval and amount

Long-term price charts point to the obvious benefits of investing, but there is a chance that you will lose money. Any cash used to buy financial instruments should be surplus to what you require to fund your daily needs. 

The nature of your personal income will also influence the interval at which you buy assets. Self-employed and salaried individuals will have differing degrees of certainty about what amount of cash will be available for them to invest in the markets. If you set the regular investment amount too high to be sustainable in the long term, the averaging process will be less effective.

Since the aim is to average the price as much as possible, this favours investing as regularly as possible. Daily investing might be considered excessive; monthly intervals would in most cases be preferable.

Dollar cost averaging in diverse market conditions  

Dollar cost averaging can be used in diverse market conditions. Many investors using the dollar cost averaging approach are drawn to stock markets and ETF (exchange-traded fund) products. This is partly because those markets have an impressive long-term track record, are relatively cheap to trade, and averaging techniques favour investors with a long-term investment horizon.

ETFs also offer instant diversification due to them being a fund-style product Diversification and long-term investing is often recommended as a way of navigating the inevitable ups and downs of the financial markets.

Navigating bull and bear markets

The key factor to remember is that dollar cost averaging works on the basis that you stick to the plan. This is the case even if markets are distressed and the value of your existing portfolio is falling. In fact, those times when everyone else is selling can be when you pick up assets at lower prices. 

During bull markets, you might take comfort from the value of your overall wealth increasing, but any new entry price might be above the long-term average of your portfolio. Whichever way the market is heading, you are insulated against some of the emotions that could result in you deviating from your strategy. 

Long-term implications of dollar cost averaging

Dollar cost averaging allows you to add an additional layer of sophistication to one of the most popular investment approaches — buy and hold. There is admittedly less chance of beating the average return for the market by investing large sums when prices are low. However, it also removes the risk of buying at the top of the market.

All it needs is some initial planning in terms of what you can afford to invest, and setting up a regular investment scheme that meets those aims. 

Final thoughts

The mechanisms used to invest using dollar cost averaging are relatively simple and, in fact, can make the whole investment process more user-friendly. At the same time, the effects can be significant because the technique helps investors to achieve two of the main targets of successful investing. It encourages investors to start gaining exposure to the markets as soon as possible and has built-in features that help investors to stick with their plan and ride out short-term volatility.

Visit the eToro Academy to learn more about dollar cost averaging and other long-term investment strategies.

Quiz

FAQs

How does dollar cost averaging protect investors from market volatility?

Short-term price crashes are actually advantageous to investors adopting a long-term view and who invest using a “little and often” approach. Trades booked during a bear market will help to lower the overall average entry price of a portfolio. Using dollar cost averaging so that extreme market events are welcomed rather than feared, can help investors to hold on to positions and reach their long-term aims.

Can dollar cost averaging be applied to any type of investment?

Dollar cost averaging can be used in any market. It is popular among investors who target stocks because that asset group is known for generating long-term gains that are punctuated by short-term price volatility. If you favour more speculative short-term strategies, or have extensive knowledge of a particular sector, then timing the market may be a better option than averaging into positions.

What are the key factors to consider when setting up a dollar cost averaging plan?

Dollar cost averaging relies on being able to invest the same amount of cash over an extended time period. Investors should ensure that the amount of their personal income allocated to the scheme is sustainable in the long term and set up a plan to invest as frequently as is practically possible.