Dollar cost averaging involves buying the same (monetary) amount of a particular stock at regular intervals. For example, you might invest $500 in Rio Tinto (ASX: RIO) on the last Friday of each month for six months.

Due to share price fluctuations, you will purchase more shares when the share price is below the original price you paid. You will purchase less shares when the stock price is trading higher. This investing strategy spreads some of the risk associated with trying to ‘time’ the market. There is no particular emphasis on how the stock is performing, or what the market is doing. Instead, you focus on regularly buying shares in a company over a longer timeframe.

This method of investing in shares involves no technical analysis. The decision to buy more shares in a particular stock is based on an arbitrary ‘rule’ that you trade at a certain interval. Fundamental analysis doesn’t exactly play a part either. There is no specific requirement to conduct fundamental analysis each time a subsequent purchase is made.

What are the Advantages of Dollar Cost Averaging?

In terms of risk management, dollar cost averaging means you are not putting all your eggs in one basket as far as the timing of your purchase.

Dollar cost averaging can help you remove emotions associated with investing. You are committing to a strategy where you will be regularly investing in a particular stock. This is regardless of how the stock is performing or what the market is doing.

If the stock falls, you benefit from not allocating all your capital at a higher price, lowering your average cost. If the company’s long-term prospects remain promising and the stock rebounds, profits will be amplified.

Dollar cost averaging is a popular strategy among Selfwealth members, gaining more traction during periods where there is a large drop across the market. It may be viewed as a practical way to budget some of your income for investing in shares.

What are the Disadvantages of Dollar Cost Averaging?

If you have committed to dollar cost averaging in order to adopt a more hands-off approach, you might find that your ‘detachment’ from any change in the fundamentals of the stock could cost you. For example, if there has been a material change in the company’s outlook. In this instance, you would be investing in shares that could remain stagnant for a long time, or continue declining.

Another thing to consider is your opportunity cost. This is the loss of alternative outcomes when one alternative is chosen. As DCA means you commit more capital to one stock, you could miss other opportunities offering more upside. By placing so much faith in a particular stock, you might even become complacent and stop researching other stocks. To mitigate this, you could dollar cost average across your portfolio.

In a rising market, each DCA purchase may end up being at a higher price than the last. There is nothing inherently wrong with increasing your average cost price. However, you should consider whether there are ‘better’ opportunities in other stocks each time you dollar cost average.

Recent data also sheds light on the performance of this strategy for investing in shares. A study by Northwestern Mutual Wealth Management shows that lump sum investing outperforms dollar cost averaging almost 75% of the time, regardless of asset allocation.

Across a longer timeframe, a study by Kowara and Kaplan analysed data between 1926 and 2019, with lump sum investing outperforming DCA investing over an average 10-year period nine out of ten times.

Does this mean Lump Sum Investing is Better?

While the above statistics may indicate a strong result in favour of lump sum investing, it’s difficult to conclude that lump sum investing is ‘better’ than dollar cost averaging. There have been shorter periods where dollar cost averaging outperformed lump sum investing, including the bear markets of the early 2000s.

In addition, one reason for all the ambiguity in terms of the ‘better’ strategy for investing in shares is due to the fact that shares have different profiles. The stock market will influence individual stocks, but they also tend to respond to company-specific events. The right strategy will also depend on your confidence levels, your investment horizon, and the amount of capital you have available to invest.

One benefit of lump sum investing is that you put your cash to work immediately. You also reduce your brokerage costs and gain full exposure to any dividends declared after your initial purchase.

The downside to lump sum investing is that you require greater conviction in your investment decision because you are taking on more risk, and potentially more volatility. Are you confident trying to ‘time’ the market?