Dollar cost averaging is investing a fixed amount of money into a particular investment at regular intervals, typically monthly or quarterly. For example, investing S$1,000 at the end of each month into the SPDR Straits Times Index ETF.
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 smoothens 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.
Most new investors do not have large sums to invest. 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.
That said, while dollar cost averaging is a simple strategy, there a few caveats to keep in mind before you jump in.
- You must have the discipline to stick to it
When the market is going down, you may feel very tempted to sell — that’s why despite the adage “buy low, sell high”, many investors end up doing the opposite — or not put in your regular investment. However, that would nullify the strategy’s basic idea of buying more of an investment when the market falls.
Conversely, you may feel exuberant and want to invest more in a rising market. But you may end up paying a higher average price or buying at the top of the market, which is what this strategy is designed to avoid.
- You still must choose the right investment
Dollar cost averaging does not spare you the work of choosing an appropriate asset to invest in. Dollar cost averaging into a bad investment is still a bad investment.
Many investors use dollar cost averaging as part of a passive investment strategy, meaning they invest in passively-managed index funds that track an entire market. This reduces the amount of personal due diligence that’s required from them compared to researching specific stocks or actively-managed mutual funds.
- Watch out for transaction costs
Regular and frequent investments mean more transactions, which might mean more costs eating into your returns. This is especially true for fixed transaction costs, such as a brokerage that charges you S$10 for every transaction. If you are just starting out and only investing S$500 a month, that represents a 2% transaction fee!
Hence, many investors who use dollar cost averaging prefer to stick to low-cost passively-managed index funds which charge a low percentage-based fee instead.
There is no such thing as a perfect investment strategy. But dollar cost averaging is a conservative strategy for building long-term wealth, especially if you are just starting out on your investment journey. Stick to the plan, and reap the rewards.
Do you want to know more about the various investment strategies you can use to help grow your wealth? Speak to one of our financial advisers at Standard Chartered today and let us help you.
This article is brought to you by Standard Chartered Bank (Singapore) Limited. All information provided is for informational purposes only.