What is dollar-cost averaging?

What is dollar-cost averaging?

Dollar-cost averaging is the process of making regular contributions into an investment or investment portfolio. Common reasoning behind this is to smooth market volatility and to mitigate the risk of a sharp drawdown in one’s investment portfolio.

The term was first coined by pioneering value investor Benjamin Graham in his book The Intelligent Investor. Graham alluded to a strategy of investing the same amount of money at regular intervals into an investment.

The investor would do this by buying more shares or units when the market is low than when it’s high. They’re, therefore, likely to end up with a lower average price of the holding compared to investing in one lump sum.

Nowadays, many retail investors around the world take advantage of the dollar-cost averaging strategy by making monthly or quarterly contributions into funds, exchange traded funds (ETFs), or model portfolios.

The below graph illustrates the price smoothing nature of dollar-cost averaging. Let’s assume the investor contributes $100 monthly into an ETF. By contributing regularly, despite market fluctuations, the investor can get a more favourable average cost.

This means that by the time the price returns to its original level, the investor would have profited from buying shares at a relatively lower price.

In the chart you’ll see that by the end of the year, the investor has made a profit of over $150 above their combined regular contributions.

Had the investor decided to invest their total monies ($1200) as a lump sum at the beginning of the period, they would’ve made no money by December as the ETF price is $1.00 per share again. Yet, they would’ve experienced significant volatility throughout the year.

* For explanatory purposes only – past performance isn’t indicative of future results.

What are the benefits of dollar-cost averaging?

• No one wants to find out that they unintentionally invested a large chunk of money at the peak of the market. Dollar-cost averaging is a way of avoiding this. As illustrated in the example above, the investor who drip fed their money into the ETF profited compared to the investor who invested it as a lump sum
• The emotional element of investing is reduced – investors may simply put investing off, especially if they believe market valuations are high. But the investor is still making regular investment contributions; hence the emotional side of investing and trying to time the market is reduced to an extent. Dollar-cost averaging, therefore, strongly encourages investor discipline

What are the disadvantages of dollar-cost averaging?

• When markets fall, dollar-cost averaging allows you to invest at a discount (relative to the initial price). But when markets rise, the opposite happens. If markets are particularly strong and going through periods of sustained gains, the investor who drip feeds their money in will be disadvantaged and make less compared to an investor who invests in a single lump sum. Markets do tend to rise more often than not
• Inflation has a damning effect on a dollar-cost averaging strategy and has a nasty habit of eroding monies’ purchasing power. Therefore, the real value of an investor’s cash reserves will slowly diminish over time as a result
• Dollar-cost averaging isn’t a silver bullet. While it helps in reducing the average price you pay for your investments and removes much of the stress around trying to time the markets, the investment choices must still be sound. If an investor gradually drip feeds their money into a poor investment, the investor could still lose money. A prudent and suitable strategy must be coupled with investments with opportunities for gain

Time in the market vs timing the market

Naturally, an investor’s dream would be to always sell at market peaks to crystallise gains, and then reinvest these profits at market troughs to maximise investment growth. However, without perhaps clairvoyancy this is next to impossible to achieve. Therefore, the best way to aim for investment growth over the longer term is to simply invest over an extended period.

The below chart exemplifies why investing over the longer term and the power of compounding is critical for generating long-term returns. Both the investment portfolio and bank deposit start with an initial $10,000 outlay; with the investment portfolio returning 5% per year, and the bank deposit earning 2% interest each year.

Over a 30-year period, the difference in returns is drastic. The bank deposit would have returned just shy of $18,000 from an initial $10,000 deposit. The investment portfolio, on the other hand, would have a value of over $41,000 – well over double the amount of the final value of the bank savings.

The reason for this is the effect of compound interest, which has a snowball effect on the returns generated when applied over long periods of time. Albert Einstein eloquently referred to compound interest as ‘the eighth wonder of the world’.