What is dollar cost averaging?

Investors may use various strategies to purchase shares in their portfolio. Dollar cost averaging is a one such strategy. In this article we discuss what it is, why it is used, and whether it is effective.

Definition

Dollar cost averaging involves the investor buying the same nominal amount of a share holdings regularly. This allows the investor to average down the cost price as purchases have been executed at different entry points. This helps prevent the investor from buying the stock at a price that is too high.

Example of dollar cost average

In the below example we have brought $10,000 worth of Kogan (ASX:KGN) each month for 6 months. The purchase prices vary a great deal and the average cost price over the 6 months was $7.86. The highest price paid was $10.54 and lowest was $5.92.

Advantages

  • Investor can reduce the risks of market timing with dollar cost averaging.
  • It can assist an inexperienced investor as they don’t need to be concerned with market timing with the dollar cost averaging.
  • It can smooth out price volatility through investing in equal amounts over time
  • It is a strategy of passive investing

Disadvantages

  • Bad stocks will continue to become cheaper so dollar averaging costing will not make the investment profitable. This passive approach to investing will just cause the investor to buy more positions in a losing stock
  • Actively selecting good stocks and investing in lump sums may be better than dollar cost averaging as stocks are selected based on fundamental or technical reasons. This is compared to passive investing where investment is automatic despite what is happening with the economy or the company.
  • The stock market generally goes up over time so dollar cost averaging would be inferior to lump sum investing for performance
  • With dollar cost averaging, there may be large balances of cash sitting in the portfolio earning very low interest. Hence this can cause returns to be lower than lump sum investing in an upmarket.

Lauren Hua is a private client adviser at Fairmont Equities.

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