The Motley Fool

What Is: Dollar Cost Averaging?

Dollar cost averaging is a technique used by investors to protect themselves from volatile markets. By accumulating shares in a particular company through investing a fixed amount of money over time, investors can help balance out the times when the market is up against the times when the market is down.

By fixing the amount you invest over time, you buy more units when the shares are cheaper but fewer units when the shares are more expensive. Proponents of dollar cost averaging claim that it is not possible to time the market. So by buying in fixed amounts regularly you could end up with some expensive shares but you could also buy shares at a cheaper price too. They claim that mathematically it makes sense.

But there are two sides to every story. Critics of dollar cost averaging claim that it leaves investors worse off when an investment moves up over time. They reckon that by not investing at the earliest possible time, investors are putting themselves at a disadvantage. That’s because they are foregoing the opportunity of reaping the benefits of higher returns by not being fully invested as early as possible. They claim that mathematically it makes sense too.

It just goes to show that mathematics can prove just about anything you want. That said, dollar cost averaging can be particularly useful if you don’t have a large lump sum to invest all at once. (And let’s face it, not many of us do.) Consequently, with dollar cost averaging, you don’t have to wait until you have saved up a large pot of money to invest all in one go.

There can also be a psychological advantage to dollar cost averaging. For example, it can be quite painful mentally if you invest a large lump sum only to find that the investment has gone down in value immediately afterwards. But if you drip the investment in over a period of time then you may not feel quite as bad. If you do intend to use dollar cost averaging, though, be aware of the transaction fees, which can eat into your returns.

Dollar cost averaging can be particularly ideal for passive investors who are investing primarily in low-cost index funds. For these investors, the focus is on keeping the investing approach simple, sleeping well at night, and yet still earning the market’s returns. For these investors, consistently investing over time in similar-sized chunks can be just what the doctor ordered.