Dollar cost averaging involves making a regular fixed investment in the stock market, say once every month or two.
Over time, you end up buying more stock when the market is low and less stock when the market is high.
It is also referred to as a constant dollar plan where you 'drip feed' into the stock market investment.
But is it a smart value investing strategy?
The idea is that when the share price is high, the regular amount buys fewer shares and when the share price happens to be low, the regular amount buys more shares.
Since you are buying more shares at lower prices and fewer shares at higher prices, you are effectively averaging down the overall price of the shares.
This stock market investing strategy is intended to reduce exposure to risk associated with making a single large purchase.
You may want to guard against the stock prices dropping shortly after making your investment.
Therefore, you spread your investment over a number of periods rather than trying to time stock market investment with a single purchase.
Research has shown that investing a partial sum over a number of time intervals generally results in worse performance compared to investing the entire sum at one time - assuming you are following a value investing approach!
The upside for the 'drip-feed' strategy is that you can expect moderately less variability (up and down) in outcome by implementing this stock market investment strategy.
Hence, the strategy can help to limit the downside of a worst-case scenario of an immediate drop in asset value if a lump sum is invested in one hit.
A similar strategy of averaging into the market, but which involves varying the regular investment depending on whether the market has risen or fallen, is referred to as a value averaging strategy.
From a value investing point of view, I prefer to be more patient, hold on to my money, and buy the shares when they offer good value; that is, below their intrinsic value with a good margin of safety. Usually, I try to buy in two or three tranches.
Then I expect to be much better off as I am timing stock market investments when the stocks are 'on sale' and not when they are sometimes cheap, sometimes dear, and sometimes in between.
However, for some investors who have limited funds and who wish to increase their exposure to the market over time, a dollar cost averaging approach may serve to not only achieve this goal but to also average down their overall investment.
The appeal may have a psychological explanation. When the stock market goes down, dollar cost averaging will save the dollar-cost-averaging investors money and they will be grinning.
And when the market goes up, they are going to be happy anyway!
In your case, it may depend on how risk averse you are in terms of handling stock market volatility. That is, whether you will have the courage to buy into a downturn in the stock market when stocks offer good value.
Or it may depend on how much cash you have available at any point in time. But why not be patient and accumulate your savings until there is a 'stock sale'?
The related article below outlines an alternative value averaging strategy.
Related ArticleValue averaging: is a strategy similar to dollar cost averaging where the investor varies the amount invested each period depending on whether the market has risen or fallen.
Search This Site