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.
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 CBA each month for 5 months. As this has been a volatile year, the purchase prices are vastly different and the average cost price was $71.74.
- This is method may be profitable in a downmarket as the investor can average down their cost base.
- 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.
- Dollar cost averaging can smooth out price volatility through investing in equal amounts over time
- It is a strategy of passive investing
- In an up market this is not a good strategy as the stock will continue to become more expensive to purchase. It would be better to invest in the stock in a lump sum and hold it as the share price appreciates as opposed to buying a parcel size of equal increments over a period of time.
- 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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