A common investing strategy in the FIRE community is called “dollar cost averaging”. Sounds pretty fancy right? Well its not. It’s generally considered to be suitable strategy for beginners and helps to avoid the pitfalls of trying to “time the market” (which no one can do sustainably). This post explains what dollar cost averaging is and how you could utilise it for your own investment strategy. I also explain my personal approach to dollar cost averaging and what I do with lump sums of delicious cash.

What is Dollar Cost Averaging?

Dollar cost averaging has a fancy name but is actually very simple. All it means is that you purchase a fixed cash value of shares/ETFs on a regular basis. By doing this, generally, the average cost of the shares you buy will be pulled downwards due to natural fluctuations in the market. We all know the market goes up in the long term, but the route for this upward trend is usually peppered with dips.

Dollar cost averaging allows you to benefit from any dips in pricing, without trying to time it.

For most people starting their FIRE journey, this will likely mean buying $X value of shares/ETFs on each pay day. In doing so, you are actually already dollar cost averaging, so congratulations! Additionally you are actively avoiding trying to time the market which no one can do with sustained success.

How can Dollar Cost Averaging Build Long Term Wealth?

The main benefit for a newbie investor (or an old hand too for that matter) is that dollar cost averaging removes the emotion out of investing. Instead of trying to time the market, you just purchase the same dollar value of shares on a regular basis. In theory, this can mean that you end up buying more shares when prices are lower than when they are higher. But it doesn’t necessarily work out like that in a rising market (see example 2 below).

The choice you face as an investor is to invest smaller amounts more regularly, or save up a lump sum and invest in one Big Bang. As is shown in the worked example below, dollar cost averaging can work to lower your average purchase price. Conversely however, you might pay more in commissions and fees to your brokerage for making multiple trades, especially if they charge fixed minimum fees per trade (check with your broker).

Worked Examples

Let’s run a couple of worked examples to show how dollar cost averaging can work in practice. The first example is set over a six month period. The second example is over a year long period. Both examples have the following inputs:

• Amount: £1,000 per month;
• Fund: VUSA ETF listed on the LSE (my favourite S&P 500 index fund for Singapore investors);
• Trade Date: first trading day of each month.

Example 1: January – June 2022

In this example, you would save £3.49 per share (on average) by investing evenly over the 6 month period, rather than investing £6,000 in one go in January:

• if you invested £6,000 in January at a price of £67.57 per share, you would have 88.8 shares;
• by dollar cost averaging over 6 months, the average price paid is £64.08 per share and you will own 93.8 shares.

Bingo, over this time period you won! But what about over a longer period, where markets where trending upwards? Let’s take a look at 2021 in example 2…

Example 2: January – June 2021

In this example, you would have lost £5.76 per share (on average) by investing evenly over the 12-month period, rather than investing £12,000 in one go in January:

• if you invested £12,000 in January at a price of £52.30 per share, you would have 229.4 shares;
• by dollar cost averaging over 12 months, the average price paid is £58.07 per share and you will own 208.2 shares.

Booooo, over this time period, you lost : ( So what does this mean? Is it all still just a massive gamble or does dollar cost averaging still have some benefits?

So dollar cost averaging works or not?

We don’t live in a perfect world. Things are infinitely clearer with hindsight.

As time plays out, the effects of dollar cost average will be more stark, especially if there is a lot of volatility in the market. However, if prices consistently trend upwards, then buying a large volume of shares at a lower price, would obviously be advantageous. As we never know what the market is going to do, then in place of having a crystal ball, dollar cost averaging is still likely to be a sensible strategy vs watching from the side lines.

Finally, the reality is that most people are paid their salary monthly and so will naturally dollar cost average in any event. Your investments will also earn dividends which will also help to smooth the ride. I think the dollar cost averaging debate revolves as much around human psychology as it does real numbers. You’ve got to do what works for you, but knowing that this investment strategy generally tends to work well.

What if I already have a lump sum?

If you already have a lump sum, you can dollar cost average or invest it in one go. Both strategies have advantages and drawbacks:

• Dollar Cost Averaging: drip feeding into the market may miss potential upside returns on a large portion of wealth.
• One Time Investment: if that the market all of a sudden crashes after you invest, and you are stuck with a high purchase twice.

There’s no sure fire solution to this dilemma. You’ve got to work out what’s best for you.

One sensible solution is to dollar cost average, but over a shorter period of time (perhaps a month). That way, you lose the “cliff edge” feeling of one giant investment, yet still get your money in the market quickly. You then still benefit from upward movements, yet get an average price calculated over a whole calendar month.

Personally, if I receive a lump sum, I will invest that in one go. I use the dollar cost averaging technique for my monthly purchases (instead of saving them up into a new lump sum). Why? Well, my thinking is that as I’m intending to be invested for the long term. Toady’s prices will always look cheap in 10, 15 or 20 years in the future. So I’m always getting a good deal.

Conclusion

I personally dollar cost average each month, come rain or shine. As tempting as it can sometimes be, I don’t time the market. As soon as I get paid my monthly salary, I transfer my investment monies to my brokerage account and place my order.

Equally if I ever receive a lump sum windfall, such as a yearly bonus etc., I invest that immediately too. Getting my money in the market as soon as possible and letting it work for me is my main priority as a long term investor.

So what do you do? Do you time the market or do you also utilise dollar cost averaging? What about for lump sums? Let me know in the comments!