Investing a fixed amount of money on a monthly basis is a popular investment strategy called dollar cost averaging.

This strategy reduces the chance of investing your money at a bad time, as your money is invested in smaller, regular intervals. Dollar cost averaging also provides a disciplined way to save for the future, as it gets you in the habit of consistently saving (and investing).

If you invest on a regular basis rather than putting all your money in at once, you can minimise the effect of a market downturn. Investing regularly, regardless of whether the market is up or down, means that you achieve an ‘average’ share price over time, rather than a single cost price for all of your money.

How dollar cost averaging works

Let’s consider Annabel and Sarah, who both have $12,000 to invest for the long term (5+ years).

Annabel invests $12,000 in January, at a share price of $1.00. Sarah invests $1,000 each month, at various unit prices on each monthly investment.

Let’s see their results.

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Over 12 months the share price went up as well as down, but by investing each month Sarah was able to purchase more shares when the share price fell. Annabel, on the other hand, didn’t benefit during the period the share price dropped. After 12 months, in this illustrative example - Annabel's return was 7%, while Sarah's was 8.47%.

#Sarah’s investment value assumes that she holds the remainder of her $12,000 in a bank account whilst she invests $1,000 per month (ie. after January Sarah has $11,000 in the bank, after February she retains $10,000 in the bank, until she is fully invested in December). Sarah receives no interest on her money while it is in the bank account.

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As you can see, Sarah’s investment value (red line) remains more stable during a market downturn, and also benefits from a higher value when markets pick up again.

When is the best time to use dollar cost averaging?

Dollar cost averaging is most effective when investment markets are volatile, and during a falling market.

During these times, dollar cost averaging helps reduce the effects of volatility and the chance of investing at a bad time.  It should be noted however, that dollar cost averaging does not guarantee a profit or a positive return. Lump sum investments can generate higher returns, particularly if you manage to invest all of your money when the market is at a low point. However, with this comes the added risk of market timing and greater variability in returns in the short term.

It is important to understand, any investment into growth assets like shares, should have a minimum time invested commitment of 7 years.

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Disclaimer:

As the above example shows, dollar cost averaging works best for assets that have a fluctuating price, or where the price falls and then rises.

By investing at regular intervals, you can possibly benefit from the volatility in the price of your chosen security over time.

The flip side of this, however, is that choosing to make use of dollar cost averaging when the market is about to go up could see your potential profit reduced.

‘Buy low, sell high’ is what any investor seeks to do, but by dollar cost averaging in a bull (rising) market, you’re buying low and buying high, which may not optimal.

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