By Priya

June 14, 2021

 
 
 
 
 
 
 
 

Show notes

🎙 Dollar cost averaging is a common investing strategy that’s often considered to be good for beginner investors and those investing under a long term buy and hold strategy. But it may not be the best option for you. How does it work? And how does using a dollar cost averaging strategy impact your wealth? 🤔

This episode discusses topics like:

  • How dollar cost averaging works and how you can implement this strategy;
  • How dollar cost averaging can be beneficial for beginners and emotional investors; and
  • How dollar cost averaging can increase your wealth and when it’ll result in you leaving money on the table.

Links from this episode:

Transcript

Hey, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women. 

My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co. 

I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.

This week we’re talking about dollar cost averaging which is an investing strategy that you may have heard of.

We’re going to talk about what it is and how it works. We’ll go through some examples and then we’ll talk about the benefits and disadvantages of a dollar cost averaging strategy. 

Oh, and I’m going to call it DCA in this episode because I don’t have the patience to say dollar cost averaging 30 times. But when I say DCA, what I mean is dollar cost averaging, so just keep that in mind.

But before we get started, I want to remind you to head to my website — papermoneyco.com/startinvesting to download your free copy of my Investing Starter guide 

It’s totally free, you just need to enter in your email address and I’ll send it straight to your inbox. 

It gives you a step by step plan to follow to get your finances ready to start investing, including working with a budget, building an emergency fund and paying off debt.

You just need to enter in your email address and I’ll send it over to you. 

The sooner you can get your foundation set and get those good money management practices in place, the sooner you can start investing and building your wealth. 

If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.

As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes. 

If you’re not into writing things out by hand, you can always find the transcript on my website — papermoneyco.com/gof24.

Okay, let’s dive in!

What is dollar cost averaging and how does it work?

First of all, what is DCA (dollar cost averaging) and how does it work? DCA (dollar cost averaging) is an investing strategy where you make regular incremental investments over a period of time as opposed to a one-off lump sum investment.

So, think of it a bit like investing in instalments. You want to invest $12,000 in the stock market this year, so instead of investing $12,000 once, you’re going to invest $1,000 at 12 regular intervals throughout the year.

Now, when you’re following a DCA (dollar cost averaging) strategy, you’re not trying to time the market to buy low and sell high. You’re investing a fixed dollar amount regardless of what the market is doing.

So, if you set the 1st of the month as your investment date, you’ll make your investment on that date come rain, hail, shine, bulls, bears or monkeys. Regardless of the price and regardless of market trends, you’re going to make your investment.

Now, the theory behind this strategy is that you’re reducing market timing risk of your portfolio. 

Essentially, you’re trying to avoid the risk of putting all your money into the market and then having the market crash the next day. Because you’re not entering the market all at once.

You’re entering it little by little. And when you do that, sometimes you’re up and sometimes you’re down but it’s smoother on average.

So, it’s a conservative approach to investing and it’s often considered to be a passive strategy that’s associated with things like index funds and ETFs which we talked about in episode 17.

Example of dollar cost averaging in action

Okay, let’s take a look at an example of how the DCA (dollar cost averaging) strategy works. 

So, let’s say that you have two investors: Amy and Belinda. They’re both going to be investing $2,400 into the stock market over the next 12 months. 

Amy invests her $2,400 of capital in a lump sum. So, to keep things simple, she invests $2,400 in one go in the A200 ETF in January. 

Let’s also assume that the current market price of A200 is $10. So, that means that Amy made one trade and bought 240 units of A200 in one go. 

And that’s it — she doesn’t do any more investing for the rest of the year. It’s just that one investment. 

On the other hand, Belinda is taking a DCA (dollar cost averaging) approach to her investing. She’s also going to invest $2,400 in A200 over the next 12 months. 

But she’s not doing it in one lump sum in January like Amy did. Belinda’s going to invest $200 in A200 every month over the next 12 months. 

I’ll have a table linked in the show notes and transcript for this episode if you want to follow along.

Dollar cost averaging when the market goes down

Now, when Belinda makes her first investment in January, the market price for A200 is $10 — that’s the same unit price that Amy paid. 

So, with her $200 investment that month, Belinda buys 20 units of A200. And she continues to do that as the year goes on. 

Investing $200 per month and buying 20 units of A200. But in May, something changes in the market and the price of A200 drops from $10 per unit to $5. 

Amy’s investment will lose some value here. When the price drops to $5 per unit, her portfolio will be worth $1,200. Because she initially purchased 240 units and then didn’t purchase any more. 

But it’s a different story for Belinda. Belinda is on schedule to make another $200 investment in A200 this month. 

But this time, her $200 investment buys her 40 units of A200, because the price per unit is lower.

Now, let’s assume that the price stays low for another two months. So, in June and July, the unit price of A200 is still $5. 

Amy’s portfolio is still valued at $1,200. It hasn’t gone up but it hasn’t come down any further either. 

And Belinda makes 2 more of her monthly $200 investments in A200 at $5 per unit. So, in both June and July, she buys an additional 40 units. 

Then, in August, the price of A200 goes back up to $10 and it stays there for the rest of the year. 

Now, for simplicity sake, we’re assuming that neither Amy nor Belinda are cashing out their investments, and they’re not getting any dividends or anything like that. 

We’re also assuming that neither of the women are diversifying their investments. We’re just looking at this one investment in isolation to compare what happens when you invest in a lump sum vs in instalments.

So, at the end of the 12 month period, in December, the A200 ETF has a market price of $10. 

Now, Amy bought 240 units of A200 way back in January when she made a lump sum investment of $2,400. 

So, in December, her portfolio is valued at $2,400. She hasn’t made any money. She bought 240 units at $10 each and a year later her 240 units are still valued at $10 each.

Belinda, on the other hand, also invested $2,400 of capital but she did it in 12 monthly instalments throughout the year. 

And because there were 3 months of the year where the price fell, she was able to buy more units than Amy did. 

So, at the end of the year, Belinda has 300 units of A200. She bought 180 units at $10 each. And she bought 120 units at $5 each. 

Now, if the current market value of A200 is $10, then that means Belinda’s portfolio is worth $3,000. That’s 300 units at $10 each.

So, you can see from this example that even though both Amy and Belinda invested the same capital in the same asset, over the course of the same 12 months, Amy isn’t making any profit.

But Belinda made a $600 profit. Because she was able to take advantage of the low price for a few months and purchase additional units. 

She essentially bought those units on sale, so when the price retuned to normal, she made a profit.

Now, that’s how a DCA (dollar cost averaging) strategy works when the market or asset prices are coming down. 

dollar cost averaging market goes down

Dollar cost averaging when the market goes up

What about when they’re going up? That’s a different story. 

So, let’s look at another example. We’re going to keep all the details exactly the same except that instead of going down for 3 months of the year, the price of A200 is actually going to go up for 3 months of the year. 

We’ll assume that in May, June and July, the price of A200 increases to $20 per unit, and then in August it drops back down to $10. And it’ll stay at $10 for the rest of the year.

Now, Amy’s investment will still be exactly the same at the end of the year. She invested at $10 per unit, and the price ended up at $10 per unit. 

She did make a gain when the price increased to $20, but she lost that gain when the price returned to $10. 

So, her portfolio is still valued at $2,400. There’s no profit or loss for Amy.

But for Belinda, when the price increased to $20, her $200 monthly investment was only able to buy 10 units of A200. So, she bought 30 units at $20 each and 180 units at $10 each. 

At the end of the year Belinda has 210 units valued at $10 each. That means her portfolio value is $2,100. And that’s a loss of $300 on her invested capital.

Now, why did that happen? Why did Belinda lose money when the market moved up but Amy didn’t. 

It’s because Amy was able to buy all her units before the price went up. She bought it at the cheaper price. So, when the price went up, she made a profit because her investment became worth more than what she paid for it.

But Belinda was buying units when the price was at it’s peak. So, when the price came down again, she was losing money. Because her investment became worth less than what she paid for it. 

So, those are just a couple of really simple examples of how DCA (dollar cost averaging) works both when the market goes up and when the market goes down. 

Of course, in real life it’ll all be a bit more complex than this. There probably aren’t many perfectly round numbers and prices will be moving up and down by the hour, not the month.

Now that we know what DCA (dollar cost averaging) is and how it works, let’s look at the benefits and disadvantages of using this investing strategy.

dollar cost averaging market goes up

FIRE & investment calculator spreadsheet

But before we move on, I want to ask my Girls on FIRE for a favour. If you’ve listened this far into the episode then you’re probably enjoying it, right?

So, here’s what I’d like you to do next. Pause this episode for a few seconds and head on over to papermoneyco.com/podcastreview.

I want you to leave a rating and review for Girl on FIRE because it helps me provide better content based on what you’re all enjoying the most.

It helps other women out in the internet wilderness come and find us.

And it’s also a great way to support this show for free, and for that I’d love to send you a little something to say thank you.

So, once you’ve done that, take a screenshot of your submitted review and email it to me at priya@papermoneyco.com or share it on Instagram and tag me @papermoneyco

If you do that, I’ll send you a copy of my FIRE and investment calculator. Which, if I do say so myself, is pretty damn amazing.

It’s how I plan for my early retirement and my wealth. It shows me how my wealth is going to grow, when I can retire and how long my money will last.

And it also has a separate tab that takes Australia’s superannuation into account as well. 

And you can use it to analyse companies and different investment options when you’re picking stocks too. 

I’ve never actually seen anything like it before, so it’s pretty special. And I’m currently not offering that spreadsheet anywhere else except on my Patreon

Not in my shop, not to my email list — it’s a ghost. So, this is kind of a money-can’t-buy type deal.

The only way to get your hot little hands on that spreadsheet is by submitting a rating and a review, taking a screenshot and tagging me in it.

That URL again is papermoneyco.com/podcastreview. I’ve made it nice and easy for you.

So, go hit pause and do that right now. It’s okay, I’ll wait. 

Okay, that concludes my little ad-break, so let’s get back to it.

Advantages and benefits of dollar cost averaging

Dollar cost averaging removes the impact of emotional investing

First up, a big benefit of DCA (dollar cost averaging) is that it tries to take the emotion out of investing. It reduces the effect that an investors’ psychology has on their investing decisions. 

And that’s because as an investor using DCA (dollar cost averaging), you’re making investments of a consistent amount at regular intervals, in the same asset, regardless of price.

You’re not trying to time the market, which we know doesn’t work because no one can predict what the market is going to do. 

By committing to making regular investments regardless of price, you don’t give yourself the choice to panic sell when prices go down and buy in excitement when prices go up. 

You’re removing the option to base your investing decisions on greed or fear. And that makes it a good strategy for both beginners and investors who follow a long term buy and hold strategy.

Dollar cost averaging reduces the volatility of market timing

Another thing to note is that DCA (dollar cost averaging) is good when the market is going down, which we saw in our example. 

If you’re investing a consistent amount at regular intervals, then when prices in the market decrease, you can buy more units with your capital.

And that means that when the market hits bottom and starts going up, prices will rise and you’ll make a capital gain. Of course, you don’t know when the market will hit bottom, no one does.

But DCA (dollar cost averaging) allows you to enter the market at multiple entry points both as the price goes down and as it comes back up again. 

And this has the effect of smoothing out the impact of market timing. Everyone’s always worried that they’re going to dump a ton of money into the market right before it goes down. 

And that’s like stepping off a cliff. You’re standing on the edge and then you take one giant step into nothing and fall to the bottom of the cliff. That’s what investors are afraid of.

And once you’re down there, you’re waiting for your rocket booster shoes or your jetpack to warm up and shoot you right back up to the top.

But with DCA (dollar cost averaging), you’re standing at the edge of the same cliff but you take the stairs down. And then you take the stairs back up.

And it’s not just one cliff. There are going to be many cliffs and many mountains as well, and you’re walking in an uphill direction. 

So, think of what’s going to happen to those two investors. The jetpack girl is going to be swinging wildly from the valley’s to the mountain tops. It’s going to be a hell of a ride. 

And her stomach is probably going to be churning the entire time. She’s going to have to make a conscious decision not to sell when she’s falling off the cliff.

But the hiker is going to take a more comfortable trip towards the valley and then start climbing back up. She won’t have those kinds of crazy swings that the jetpack girl does.

So, a DCA (dollar cost averaging) strategy protects your portfolio from that kind of volatility in the market. 

It smooths out those fluctuations because your overall cost base is an average of all those entry points on the way down and the way back up again.

But of course, that’s also going to depend on the asset itself. The stock market does have a lot of volatility in the short term, but some stocks are going to be more volatile while others will be more stable.

Disadvantages of dollar cost averaging

Betting on the market to go down instead of up

Now, let’s look at some disadvantages. The biggest disadvantage here, is that the market tends to go up over time. That’s just how it moves in the long term. 

It might have all sorts of peaks and valleys in the short term, lots of volatility. But in the long term, the market trends upwards. 

I think it was in episode 14 or 15, but remember what I said — if in doubt, zoom it out! Look at those stock market trends over the long term and you’ll see it moving upwards.

Despite the Great Depression, despite the GFC in 2008, despite the COVID crash last year. And despite all those economic crises in between.

But when you use a DCA (dollar cost averaging) strategy, you’re assuming that the market is going to go down first, allowing you to buy up more units at a cheaper price.

And then, it’ll move up, which is when you’ll make a profit on your discount units.

And we could see that in action, right? With the examples we looked at earlier. In the first example, prices went down and then returned to normal. 

And Belinda made a capital gain on her investment. But when prices went up, which is what the market does in the long term, she didn’t do so well. She actually made a capital loss of $300.

Delaying entry into the market sacrifices compounding

Now, following on from that, a key disadvantage of DCA (dollar cost averaging) is that you delay the entry of a lump sum windfall into the market. 

And we know that time in the market is crucial because it allows your interest to compound. The more compounding it does, the more profit your profit makes, the richer you get.

This is why we want our cake to bake for the full baking time. We don’t want to pull it out too early when it hasn’t had enough time to cook and it’s all still batter.

But by holding back a large lump sum so that you can split it into instalments, you’re giving up some of that time.

And we could see that in the examples of Amy and Belinda as well. They both invested the same amount of capital. Amy invested in a lump sum so her $2,400 had the full 12 months of growth.

But Belinda only had $200 getting the full 12 months of growth. And she also had $200 getting only one month of growth.

Even though both women invested the same amount of capital for the same period of time.

Dollar-Cost Averaging: Truth and Fiction (Morningstar research)

Now, some smarty pants people at Morningstar actually did some research and published a paper called Dollar-Cost Averaging: Truth and Fiction. 

I’ll leave it linked in the show notes if you want to check it out.

But what they found was that historically, DCA (dollar cost averaging) has actually produced lower long term results than lump sum investing

They said that on average, DCA (dollar cost averaging) doesn’t make you wealthier. 

Because when the market goes up (which it alway does in the long term), the longer you delay your investment, the more likely you are to miss the gains you could be earning. 

In their research, they found that 9 times out of 10, an investor who dribbled money into the market would have ended up with less money than if they had put all their money into the market in a lump sum at the beginning. 

They also said that holding money back and investing it later like you do with DCA (dollar cost averaging) only makes sense when the investor believes that prices will go down for a while and then come back up.

And we could actually see that in action when looking at the examples of Amy and Belinda.

Of course, research and examples aren’t foolproof but it’s just something to think about.

Other disadvantages of dollar cost averaging

Another thing to consider is that when you’re making investments at regular intervals, you’re going to incur more costs. 

And I’m talking about things like brokerage fees and commissions here, which we talked about in episodes 3 and 4.

Not only that, but your portfolio isn’t very dynamic or responsive to change in the market. 

Because with DCA (dollar cost averaging), you’re investing the same amount consistently in the same asset at regular intervals.

You’re not choosing the hot new investment in town. And in some ways, that’s okay, because you’re sticking with a long term buy and hold strategy instead of trying to day trade the hot new investment.

But some new investment opportunities are good ones. They’re not all fries for the day trading seagulls to chase after. They can be solid investment choices, but you miss out on that with DCA (dollar cost averaging).

How Priya invests

Okay, so before we end this episode, let’s talk a little bit about how I invest. 

So, I don’t follow a DCA (dollar cost averaging) strategy. In a way, the mandatory contributions into my superannuation retirement account, which is like my 401(k) for my listeners in the US, is dollar cost averaging. 

It’s a consistent amount invested in the same mix of assets on a regular schedule. And it’s invested by a superannuation fund manager, not me, so none of my emotions or psychological bias is involved.

But all I really get to decide with my superannuation is how aggressive or conservative I want my fund manager to be when they invest my money. And that’s literally just choosing a setting on a website. So, I don’t really count that.

For our purposes today, and most of the time, we’ll be talking about my brokerage account because I make all the investing decisions there myself.

So, I make a monthly investment every time I get paid. And sometimes the amount is higher, sometimes it’s lower. 

It just depends on what else is going on with my finances and my budget at the time and how much money I have to dedicate to investing. 

Now, that’s not me trying to follow a DCA (dollar cost averaging) strategy. 

It’s honestly just based on when I have the money available. I get paid monthly, I have money available to invest monthly, so I make a monthly investment. 

It also makes sense for me to invest monthly based on my income level and the brokerage fee I pay every time I make an investment.

I would prefer to make lump sum investments to get in as early as possible and allow my money more time to compound and grow.

So, if someone gave me my entire annual salary tomorrow, I would make a lump sum investment from it.

I’m also not always investing in the exact same asset every month. I invest based on my investing strategy and asset allocation which we talked about in episode 17.

When I receive a lump sum of cash, however, like my tax return, I invest it as a lump sum in addition to the investment I make from my salary.

I don’t apportion it over my monthly instalments, because I want that money to have the maximum amount of time to grow in the market. I want my cake to bake for as long as possible.

So, that’s what I personally choose to do. I just invest money when it’s available to me. 

And it just so happens that my money is available to me in regular monthly instalments.

For your own situation however this may depend on a range of variables such as how much of your income you have available to invest at any given time and how much you pay in brokerage per trade. 

For a quick breakdown on an ideal investing cycle for you, I recommend plugging a few numbers into an investment frequency calculator. I’ll leave the one that I use linked in the show notes.

Next weeks’ episode

And that’s all I have for you Girls on FIRE today!

My challenge for you this week is to head to papermoneyco.com/startinvesting and download your free copy of my Investing Starter guide.

It gives you a step by step plan to follow to get your finances ready to start investing, including working with a budget, building an emergency fund and paying off debt.

You just need to enter in your email address and I’ll send it over to you. 

The sooner you can get your foundation set and get those good money management practices in place, the sooner you can start investing and building your wealth.

On next weeks’ episode we’re going to be talking all about dividends which are an amazing way to earn some passive income.

I also have a huge and very exciting announcement coming out in next weeks’ episode too. So, you absolutely don’t want to miss it. 

And let me give you a little hint — you definitely want to get your hands on that Investing Starter guide before that announcement drops. Trust me on that one. 

So, do yourself and your finances a favour and grab it now.

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Disclaimer

The advice shared on Girl on FIRE is general in nature and does not constitute financial advice. The information shared does not consider your individual circumstances. Girl on FIRE exists purely for educational purposes and should not be relied upon to make an investment or financial decision.


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