Dollar cost averaging is one of the time-honoured methods of investing. It is also popular as you do not need a lump sum to start. It is easy to apply and takes the guesswork out of when to invest.
But how does dollar cost averaging work and are there are pros and cons?
What is the definition of dollar cost averaging?
The definition of dollar cost averaging is an investment strategy where you invest a fixed amount every month over a long period of time. By doing so you can smoothen investment risks.
Basically, you are investing a fixed amount into a particular stock, unit trust or mutual fund over time at periodic intervals (the most common option is monthly). This means you will buy more units of the shares or unit trust when the price comes down and fewer units when the price is higher.
For example, instead of buying 1 lot of Keppel Corp of shares at $10,800 at one go, you may invest $1,000 a month in the counter and accumulate 1 lot over slightly under a year. Or invest $500 each month and accumulate 1 lot over approximately double the amount of time.
Unless you give instruction to stop the investment, the same amount will be deducted from your account on the same day each month to buy Keppel Corp shares at the prevailing market price.
What are the pros of dollar cost averaging?
Instead of wiping out your annual bonus on 1 or 2 blue chips, and then checking mobile apps like Bloomberg every other hour to see if the price has moved up, dollar cost averaging (DCA) is low-risk and requires little monitoring.
1. Takes the impulsiveness and guesswork out of investing
Even for seasoned investment professionals, DCA is a means to invest regularly, recognising that nobody can predict whether a stock price will go up or down or pinpoint a perfect time to buy into an investment.
The only time it is really safe to scoop up massive amount of stocks is usually in the aftermath of a financial crisis. This is when everything including fundamentally sound blue chip shares are going at steep discounts of 40% and above. This is one of Warren Buffet’s classic rules of investment: “Be greedy when others are fearful.”
However, at most other times, and especially when the markets are going sideways, DCA is a disciplined, unemotional and balanced approach to get exposure to the stock markets without worrying too much.
2. Gives you exposure to the stock markets, which tend to go up over time
Minus the noise of daily fluctuations, history has shown that stock markets do go up over time. Especially aggregated stock indices, like the Straits Times Index (“STI”), a basket of 30 stocks representing 14 different sectors. Over the past 10 years, it has delivered average annualised returns of 9.2% per year. This does not include dividend payouts of about 3% per year.
Similarly, the US S&P 500 also delivered average annualised returns of 9.1% per year over the past 10 years. Stretching the time horizon further into the past 50 years, average annualised returns were 11.3% per year.
This means that even if you’re lazy or time-strapped to constantly monitor your investment portfolio, DCA is a proven strategy to ensure you ride out the volatility of the market.
3. It makes investing accessible to the masses
Many people think that investment is only for the rich. If you’re wondering how you can start investing with no experience, dollar cost averaging is a relatively low-cost strategy.
In fact, with as little as $100 to spare each month, you can buy into blue chip Singapore stocks like DBS Bank, SPH, ComfortDelgro, Singtel and CapitaMall Trust. This option was launched by POSB and OCBC bank and presents a great, cost-effective way to dollar cost average into blue chips and the STI.
This option has been available for unit trust investments for a long time. Known as ‘regular savings plan’, after making the initial lump sum investment (which is $1k in most cases), you may invest a fixed amount monthly into the same unit trust. The good news is, besides for the benefits of dollar cost averaging, these monthly investment amounts are also free from sales charge (please check with your bank) up to a certain cap.
So, are there any downsides of dollar cost averaging that one should be aware of?
Potential cons of dollar cost averaging
1. Cheap gets cheaper for a lousy stock
Regardless of whether you are investing in a lump sum or in small amounts regularly through dollar cost averaging, a lousy investment still remains as such. These are shares or unit trusts that are on a prolonged downtrend or going sideways for a long time.
2. When markets are at bottom, you don’t get the most out of your investment with dollar cost averaging
The only scenario where DCA does not benefit your investment is when markets are on a confirmed aggressive uptrend, which is usually the case when financial markets recover from a crisis. In this case, if you have the means, you will get higher returns buying stocks in full lots upfront rather than averaging in over time.
Final Note: All in all, dollar cost averaging is a sound approach to making investments as it takes the impulsiveness and guesswork out of investing. Markets also generally go up over time and you will benefit from the long term upside of staying invested. It is also potentially more rewarding way to save from your salary monthly rather than keeping the money in cash.
What are your thoughts on dollar cost averaging? Have any experiences to share? Let us hear you out here!