Dollar cost averaging refers to making investment purchases at regular intervals of time. The purpose is to average out the price (cost) of the investment by buying investment shares at different prices over time. This strategy reduces the risk of making a large lump sum investment and then watching the market fall shortly after, which is something most investors would like to avoid.
Most investors use dollar cost averaging because they get paid in regular intervals and often will invest a bit from each paycheck. Some investors will save up their contributions and then make a larger purchase when they feel the timing is right – this is called a lump sum purchase. Another scenario where an investor would have the option between dollar cost averaging and doing a lump sum might be if they receive a large bonus from work or possibly an inheritance.
Which is better – dollar cost averaging or lump sum purchase?
In a rising market (bull market)
- A lump sum purchase would be better because then all the money is invested in the market right away and can get the full benefit of the rising prices.
- Dollar cost averaging means that you are buying less units of the investment as it goes up so you are basically losing out on some of the gain compared to the lump sum purchase.
In a falling market (bear market):
- Dollar cost averaging is better because as the prices go down, your purchases will buy more units or shares of the investment.
- Lump sum doesn’t work out so well because all the investment shares you purchased have gone down in price.