What is dollar-cost averaging and is it a good investment strategy?

The share market is characterised by regular bouts of volatility, and even the most experienced traders sometimes have difficulty pinpointing the best times to invest. One strategy for dealing with this uncertainty is dollar-cost averaging (DCA). 

In simple terms, this involves investing a fixed sum of money into shares at regular intervals, regardless of the price. The idea is that by sticking to a strict investment schedule, you can reduce your average cost per share over time.

Short-term volatility is a feature of the share market, but historically prices tend to trend upwards. If you can look past this volatility and invest at regular intervals, you’ll be able to buy more shares when prices are low and less when they’re high.

Over time, the average cost of your investments would add up to less than if you tried to time the market and buy in at the opportune moment (which is extremely difficult to pull off, statistically speaking).

If you’re a working Australian, you’re actually already participating in DCA through your superannuation fund. Each time your employer makes a contribution, it’s invested on your behalf across a range of assets (think shares, property, and fixed interest assets such as government bonds).

While the dollar amount you invest at each interval remains the same (at least until your pay increases), the number of units purchased will vary based on how the market is performing at that particular time.

Let’s say you’ve committed to investing $1,000 each month in an Exchange Traded Fund (ETF). No matter which index the ETF tracks, there will likely be months when it’s up and others when it’s down.

A DCA strategy can help you ride out these fluctuations. Yes, your $1,000 will buy fewer units in months where prices are high, but this is balanced out by the discounted purchases you make in other months.

Can lower your average cost per share

At the core of DCA is committing to making regular investments, regardless of any ups and downs in the market. Doing so can help smooth out the cost of your purchases over time and keep you from going all in when prices are at a high point.

It also ties into a strategy known as buying the dip, which involves purchasing an asset (typically one with strong fundamentals) when prices have gone down. The goal, of course, is to reap a tidy profit when prices eventually rebound.

Less mental effort than trying to time the market

A DCA approach can be preferable for those who aren’t all that interested in regularly monitoring the market for “ideal” investment opportunities. This can be both time-consuming and emotionally draining, and there’s no guarantee that it will produce the results you want.

Takes emotions out of investing

Markets produce plenty of noise, and sometimes that noise can rile up our emotions and cause us to make flawed decisions. A mechanical approach to investing can be a good way to keep level-headed in the face of wild price swings and avoid trading in ways that aren’t aligned with your goals.

Higher transaction costs

Perhaps the main downside to DCA is the higher brokerage costs. Brokers typically charge a fee to execute a buy or sell transaction, and if you’re making frequent investments these can add up over time.

The good news is that, if you’re committed to investing large amounts over the long-term, the money spent on brokerage fees should be insignificant relative to your portfolio. And there are a number of low fee share trading platforms to choose from if cost is a concern.

Not as effective in a rising market compared to lump sums

Another thing to remember is that DCA works best as a strategy for dealing with price fluctuations over time, and won’t be ideal if prices are trending in one particular direction. For example, DCA will purchase fewer shares in a bull market (one where prices are continuously rising) compared to buying a lump sum at the start.

For more information on investing strategies, read our guide to share trading for beginners. And if you’re looking to start trading but aren’t sure where to start, browse our picks for the best share trading platforms in Australia.