The phrase 'dollar cost averaging' (DCA) gets thrown around a lot when talking about strategies for buying shares. But what exactly is dollar cost averaging? And how can it help or hurt?
Here we take a look at what DCA is, its pros and cons, and why this approach could suit investing in ASX shares during the current bear market.
The dollar cost averaging theory
The idea behind DCA is simple. In its purest form, it involves making regular share purchases regardless of the share price. The most obvious example is your superannuation. Whenever your employer makes a contribution on your behalf, it is split up and allocated to your basket of assets, regardless of their prices and movements at that time.
The superannuation scenario of DCA takes place over a huge time frame and across multiple assets. However, with the current coronavirus-induced market crash you may be looking to employ this strategy over a much shorter time frame. And probably into some individual ASX shares.
Under these circumstances, the DCA method of investing is in contrast with lump sum investing (LSI), which is essentially investing your total sum in the desired asset in one transaction.
Does dollar cost averaging help or hurt?
As with most choices in life, a DCA strategy has its positives and negatives.
The negatives
Dollar cost averaging can help you obtain a lower average share price for an asset, under certain scenarios. However, under most scenarios it may actually hinder your returns if you're too slow to deploy cash into the shares.
This is actually quite logical if you consider that the All Ordinaries (ASX: XAO) tends to increase over time, more often than it declines. In this context, holding cash and waiting to invest it each month or quarter via a DCA strategy means it earns an almost zero percent return while the market (generally) trends upwards.
The positives
However, these are not general times. In fact, over the last 5 weeks the S&P/ASX 200 Index (ASX: XJO) has lost around 31% of its value – a figure which would've been far worse if I had written this article a couple days ago.
In this scenario, investors may find themselves trying to invest during the market's bottom – this is an improbable feat and may see you invest a lump sum right before the market takes another dive. This is why I think a DCA strategy can work well during relatively short times of high volatility.
Following a DCA strategy, investors are able to essentially minimise any short-term volatility in the asset, 'averaging out' its share price (this strategy also potentially saves an investor's sanity!). This is a strategy that works best over highly volatile growth shares such as Afterpay Ltd (ASX: APT).
However, I think the main benefits from a DCA strategy are psychological. Consider having made a lump sum investment just before the shares take a dive and having no funds left to 'average down' your holding. This would leave many investors feeling a world of pain. Compare this to a strategy that invested in 2 or 3 equal-sized packets over the share's decline.
The problem with this scenario, however, is that by following a DCA strategy you are essentially taking the view that you think the shares will trade lower in the future – something that we know (on average) isn't true.
How to employ a dollar cost averaging strategy
The best way to employ a DCA strategy is to:
- Choose your ASX share, ETF or LIC to buy
- Choose the time frame over which you wish to employ the strategy (reduce price volatility)
- Divide your lump sum into a few equal sizes or 'packets'
- Invest these packets equally throughout the period.
The investment period can be weekly, monthly, quarterly, etc. However, it's important not to divide the lump sum into too many packets, which makes the investments too small and results in high transaction costs. As a general rule, I would try not to invest with sums less than around $1,000.
Investing with equal amounts is also superior to buying the same number of shares each period, because it results in buying more shares at lower prices, and less at higher prices.
To demonstrate, we compare the 2 methods below: investing $1,000 across 3 periods versus buying 100 shares across 3 periods. We look at how both strategies play out under 3 different scenarios – a fluctuating share price, decreasing share price and increasing share price.
Source: Author
You can see that investing the same amount each time results in a lower average share price under each of the 3 scenarios.
Foolish takeaway
The benefits of a DCA strategy are mostly psychological. However, it can also help you to avoid bad timing from a lump sum investment and reduce your share price volatility. And with volatility currently gripping the market with huge swings each way (although mostly down lately), I think it would be a great strategy to deploy over the coming months.
Instead of trying to time the market bottom, let's try to invest through it, if you have the opportunity to do so. That's what I plan on doing, by consistently adding capital into great ASX shares.
