The Wonders of Regular Investment: Dollar Cost Averaging

Dollar Cost Averaging is a very simple automatic technique that reduces risk when building an investment portfolio. It is simply the act of regularly investing a fixed amount in an investment. If the price is high you will buy fewer units (or shares) and if the price is low you will buy more of them. It lends itself best to managed fund investment (e.g. mutual funds, unit trusts or OEICs) because it is possible to buy a fraction of a unit and there is usually no dealing charge (just a spread between bid and offer prices) so small regular investments do not cost more than lump sum investments.

The way this strategy works is the amount invested is fixed (i.e. rather than buying a fixed number of units) so more units are purchased on days when the price is low and therefore the average price paid is lower than actual average price over those days. The more volatile the price over the investment period the lower the average price paid relative to the real average.

The Maths: Dollar Cost Averaging

The average price paid per unit or share is actually the harmonic mean rather than the arithmetic mean - The harmonic mean is the reciprocal of the arithmetic mean of the reciprocals.

Return = Price / P(harmonic) -1

where P(harmonic) = harmonic mean = n / (1/X1 + 1/X2 + 1/X3 + .... + 1/Xn)
for a series of n numbers X1, X2, X3, ... Xn

P(harmonic) >= P(arithmetic)

so the return from DCA will generally be more than for the same amount of money invested in a fixed number of shares or units each month.

It all sounds too good to be true. You a are guaranteed to get a price better than the average over the investment period, but in a steadily rising market, you will actually get a price higher than at the start of the period (i.e. you would have been better making a lump sum investment at the beginning) and in a falling market you may have been better wait to the end of the period to invest. DCA does however work very well in volatile markets when the direction is uncertain.

Another problem is fees. If you buy exchange traded funds (ETFs), investment trusts or shares, or any other investment with a fixed trading fee per trade, you will have to pay that fee every month so it may only make sense if the fees are low or the invested sums quite large (although some brokers such as SelfTrade and Interactive Investor) actually reduce the fees for regular investment (just £1.50 per trade) which may make DCA viable even for small sums of money. This is not a problem with unit trusts, mutual funds etc. because there is no trading fee, but the bid-offer spread and annual management fees etc may be quite high.

Most traders and investors will try to time their purchase of shares, stocks, bonds etc. by using techniques such as Technical Analysis (i.e. "Charting") or Fundamental Analysis to determine either when a stock price is likely to move higher or when the price can be considered good value. Both of these methods can (with a lot of practice and effort) give better results, but do require constant monitoring to get the best results. Dollar Cost Average investing requires very little effort.

O.K. so if you are a trader or even an active investor this will all sound rather dull, but there are two main stages in a successful trade: buying and selling. Dollar cost averaging may passively get you a good average purchase price, but if you are investing for capital gain you can determine when you want exit the position. e.g. when you have a decent gain compared to the average price paid you can sell and move on to the next "trade". If you are trading unit trusts or mutual funds, however you will never know exactly what price you will get when you sell, because they are priced on a forward basis i.e. you will get the price at the next pricing calculation (typically the following trading day) so there is some uncertainty and you may only want to use this method once gains have significantly exceeded typical daily volatility.