What is dollar-cost averaging?

 

Big money windfalls are always welcome. Whether it’s getting a bonus from your employer, a fat tax return, or even a winning lottery ticket – the extra cash always comes in handy.

Assuming you’ve got your expenses under control and have saved up an adequate emergency fund, you may be thinking you’d like to invest your newfound wealth. And you already know that letting it sit in a so-called high interest savings account won’t cut the mustard because of taxation and inflation, right? Maybe you’re even thinking about a passive investing portfolio – similar to what Clover offers.

The question you may be asking is whether you should invest all of the cash at once, or just a little bit at a time? The latter technique is what’s known as dollar-cost averaging and it’s important that you understand it, because it can help to make you a more disciplined investor.

How does it work?

The gist of dollar-cost averaging is as follows: you buy a fixed amount of whatever securities you’re invested in (e.g. ETFs) on a set schedule, regardless of the share price. Some of your purchases may be at a higher price and some lower, so you end up averaging out the purchase price. Investing regularly helps you manage the timing risk and is likely to reduce portfolio volatility.

But there’s really two types of dollar-cost averaging. The first is when you use something like automatic deposits to invest a portion of your income on a regular basis. This is widely accepted as good financial practice and we recommend doing it.

The second type is a situation like the earlier example, where you’ve got a large lump of money and are unsure if you should open the floodgates and invest the whole lot, or just let it trickle into your money pool. This is the one we’ll discuss in more detail.

Let’s say you’ve gotten a nice work bonus of $50,000 and you want to invest that money in an ETF sharemarket fund with a share price of $50. You decide that you’ll invest that money gradually – $5,000 per month for ten months.

The first month, you buy 100 shares (since the price is $50). The following month the share price price rises to $125, so your $5,000 buys you 40 shares. On month number three, the share price of the ETF drops to $25 so your $5,000 buys you 200 shares. And so on.

So, does this mean dollar-cost averaging is the best choice?

Well, you may be surprised to know that that the greatest benefit from dollar-cost averaging is actually psychological. Vanguard wrote an interesting post where they discuss how dollar-cost averaging forces investors to take a disciplined, non-emotional approach to investing.

This means that investors don’t get spooked when the market falls, or get too excited when it rises. That’s important, because it discourages trying to time the market. And there’s ample evidence to support that timing the market is not an ideal approach for the vast majority of investors.

Ok, so back to our example – is trickling the $50,000 into a fund better than investing the entire lump sum? Well, that depends. If you’re investing in something heavily weighted in the sharemarket (like our example ETF) and are looking at a long-term time horizon, AND you’re ok with the risk involved, then you may be better off choosing to invest the lump sum at once.

This is backed by a well-known Vanguard study showing that lump sum investing in the sharemarket gave better results than dollar-cost averaging ⅔ of the time. Moreover, the longer the investment time-frame, the greater the chance for a favourable outcome. The reason is pretty straightforward – the longer-term trend for sharemarkets is upwards, which means that by investing your money early, you can take advantage of compounding.

But, this same study also stresses that dollar-cost averaging may be a better choice if an investor is more concerned with mitigating short-term risk and FOMO. It really depends on an individual identifying their own level of risk and investment time horizon.

The verdict

For many investors, dollar-cost averaging is a forthright way to build wealth and to not lose sleep over market fluctuations. The real value of dollar-cost averaging is that it helps to take the emotion and stress out of investing by forcing investors to be disciplined. When you remove the emotion from investing, you remove the likelihood of making bad choices. And bad choices can cost you a lot of money.

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