What is dollar cost averaging?
Dollar cost averaging is investing a fixed amount of money into a particular investment at regular intervals, typically monthly or quarterly. This strategy, with its potential to mitigate timing risk, is most often employed for riskier investments such as stocks and mutual funds (as opposed to bonds or real estate).
The fear of entering the market at the wrong time can lead to inaction or hasty decisions. Dollar cost averaging smooths out fluctuations, as you buy more shares when prices fall and fewer shares when they rise. This is the strategy’s cost-averaging effect.
Dollar cost averaging is also a long-term strategy. Barring adverse circumstances, it helps you gradually build up your holdings of a particular investment over an extended period of time.
From an emotional perspective, dollar cost averaging keeps things simple. Regardless of market fluctuations, you invest the same amount of money each month. As long as you have the discipline to stick to it, you will be less emotionally affected by market volatility and less prone to making rash investment decisions.
How to calculate dollar cost averaging?
Let’s say that an investor named Mr. Lee invests S$1,000 per quarter for 1 year into the SPDR Straits Times Index ETF. Now the price of the ETF may change each month, but the amount Joe invests never changes. Theoretically speaking, as long the ETF increases in price over that time period, Mr. Lee will have successfully used dollar cost averaging to see a positive return on his investment.
Period | Market Price | Amount Invested | Shares Purchases | Shares Owned |
---|---|---|---|---|
Q1 | 20 | S$1,000 | 50 | 50 |
Q2 | 12.5 | S$1,000 | 80 | 130 |
Q3 | 20 | S$1,000 | 50 | 180 |
Q4 | 25 | S$1,000 | 40 | 220 |
Total Cost | Current Value | Total Gain If Sold |
---|---|---|
S$4,000 | S$5,500 | S$1,500* |
Most new investors do not have large sums to invest and don’t always know where to begin. Typically, as their earning power increases, they will have spare cash each month to allocate to their investment portfolio. Dollar cost averaging is thus the ideal strategy for new investors looking to build a long-term portfolio. It also provides for a very hands-off approach which can be ideal for the inexperienced investor.
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