Does Dollar Cost Averaging Work?

What is “Dollar Cost Averaging”?

“Dollar Cost Averaging”, as the words imply, it means averaging the dollar cost of a particular stock acquired across fix interval of time with consistence investment amount, regardless of the value.

How it works?

This is one of the statistical ways (averaging is one of the statistical methods) to systematically lower market risk. It helps investor to capture more units at various market prices, rather than only once at peak or lowest. With this, it lower downs the cost per unit of the shares acquired. From psychology aspect, it spread the short term fear with extended period of systematic investment plan.

Average cost per share = Total Purchased Price / Total Purchased Units

As the word ‘dollar’ usually refers to US dollar, some prefer to call it in other currency term such as Yen Cost Averaging (for Japan), Ringgit Cost Averaging (for Malaysia), and Pound Cost Averaging (for UK).

How to apply this method?

The simplest way to apply this method is by investing fix amount of dollar from your earning or salary into investment account, in fixed interval (daily, weekly, monthly, quarterly or yearly).

Pro

This method is as easy as 1-2-3 to follow. Basically, it reduces volatility of your portfolio by acquiring more units when market is low and less when market is high. Investor who is reluctant or lazy to do his home work, study the market and make calculative decision while doing share investment is suitable to apply this methodology. Without knowing the peak or lowest point of the market, “dollar cost averaging” simply helps you to average the cost per unit for the particular share you invested.

Another type of investors who is suitable with “dollar cost averaging” methodology is those without excessive of lump sum cash to invest. “Dollar cost averaging” allows investor to capture the market in smaller pieces into this basket. In long run, it accumulates wealth for retirement for example.

Cons

Better return if you can time the market with lump sum investment. “Dollar cost averaging” makes you an “average earning” investor. In order to maximize the earning from share market, investor required to “time” the market and get in at the lowest point. However, this is nearly impossible. Or else, the you need to equip with high level of technical skill and knowledge, experiences and stable psychology to make the correct decision at the critical timing.

Potentially increase transaction charges. Compare to lump sum investment, “dollar cost averaging” could cause higher transaction fees if the brokerage fees are charged based on number of transactions. For example, if each transaction cost $25. 10 times of transactions will cost $250. However, if the transaction charge is based in percentage, this will benefit the “dollar cost averaging” method. No matter how many transactions were done, the total transaction fees will be remain the same percentage of total invested amount.

What is the assumption for this method?

This method assumes the stock price will increase in long run, for example across 5 or 10 years or even longer period. Rationally, a healthy, stable and well managed company should grow its profit yearly as it is actively managed. This simply implies that the company value and hence stock price will increase across years in tandem.

What is the effective ways?

One of the common methods to overcome the weakness of dollar cost averaging is by using “Value Cost Averaging”. Basically this method allocate more funding when the share prices are lower. While reduce the funding when the share prices are higher.

The investment amount did contribute to the effectiveness of this method. For example, if the initial investment was $1,000 and follow by monthly investment of $100 monthly. It will take 10 months to effectively average the price weight of the first investment. Therefore, the result from this “dollar cost averaging” might take longer time to reveal.

Summary

No doubt, “dollar cost averaging” was the simplest method that widely recommended by financial advisor. The result of this method has proven record based on historical data, if it was applied to a healthy stable growing company share. By taking into account of the transaction fees as well as each averaging amount, the result could be very effective. For even better return, investor could couple this method with “value cost averaging” methodology.