You may have heard the term 'dollar cost averaging' (DCA) used before. Whether you are just starting out or are a seasoned investor, using DCA can help significantly with securing the lowest buy price for your ASX shares.
What is dollar cost averaging?
The goal of DCA is to secure the lowest average buy price for a share over a specific period of time. When used correctly, DCA can reduce the impact of market volatility, provide you with more options and generate a higher, long-term return on your investment.
This can be very useful in uncertain markets, such as the one we are currently in.
Here's how it works:
Say I plan to purchase $10,000 worth of the (fictional) company, XYZ Co. XYZ shares are currently trading at $10 per share. If I invest all $10,000 today, then I am locked in at today's prices of $10 and I can purchase 1,000 shares.
However, if I spend $5,000 today and hold $5,000 in reserve, I can create a second buying opportunity, potentially at lower prices. In the example above, if I secure 500 shares today at $10 each and then the share price dips to $8 next week, I can use my $5,000 cash reserves to secure an additional 625 shares. This brings my total to 1,125 shares for my $10,000 spend.
Waiting for a lower price to deploy my cash reserves has meant that I now have an additional 125 shares and that I have now paid an AVERAGE of $8.88 per share.
How can dollar cost averaging help in a volatile market?
Dollar cost averaging can be particularly effective in market crash scenarios and, in this case, it's hard to beat as an investment strategy.
Referring to the above example again, lets look at what could happen in a market crash, similar to what we have seen with COVID-19. In this scenario, I purchase $5,000 worth of my XYZ Co shares, trading at $10 a share and this gives me a holding of 500 shares. In a severe crash, a share price can drop dramatically. This might mean my XYZ holding falls to $4 a share.
Normally, this would be a test of the nerves of even the most seasoned investors, however, a DCA strategy would mean that you would welcome this kind of volatility in the short term. I now have the opportunity to deploy my remaining $5,000 into XYZ shares at $4 per share, giving me an additional 1,250 shares! My holding is now 1,750 shares (75% more than if I spent all $10,000 in one transaction) and my average price is $5.71. This is a significantly better position to be in as an investor caught in a crash.
As a variation to the above strategy, I could potentially split my $10,000 over 10 monthly purchases of $1,000. Again, this will give me the best average price over this period (10 months).
Risks and costs
Dollar cost averaging is effective in a falling market, however a rising market might mean you miss out on a larger position initially. This needs to be taken into account when you consider the use of DCA.
Transaction costs can also be higher when using a DCA strategy, as you are paying your broker multiple times. For example, if a broker charges a flat rate fee of $10 per trade, you are now doubling (or multiplying) your fees with each subsequent purchase.
Foolish takeaway
Personally, I use dollar cost averaging every time I plan to invest for the long term. This has always provided me with a lower average entry, higher long-term returns and most importantly, peace of mind.
While a market crash can be stressful, if you employ a DCA strategy, you will begin to welcome the short-term volatility, which can be quite a different investing experience!
