Looking for an investment strategy that can reduce risk and save time while still growing your money? Well, through dollar-cost-averaging (the practice of making smaller investments of equal amounts at regular intervals), you can achieve all of these things. To give you some insight into the main benefits of this investment strategy, we’ve put together a brief overview.
Key takeaways:
- Not knowing if the price paid for an investment today will generate returns in the future can be summarized as timing risk
- Dollar-cost-averaging (DCA) is an investment strategy that aims to reduce an investor's exposure to timing risk
- To implement a DCA strategy, investors make equal investments at regular intervals - regardless of the price
- There’s no requirement for how much you have to invest, and it can take some of the emotional load off making investment decisions
- Making regular investments can be a path to financial freedom as it can lead to increased total returns over time through compound growth
Investment timing & risk
Investment decisions are mainly driven by two factors: risk and return. And more often than not, there’s a trade-off between the two – meaning when the potential return of an investment is high, the risk also becomes high (read more on the basics of risk).
A similar trade-off exists when making one-off (lump sum) investments. The larger the sum of money, the more the timing of the investment matters because you want to be sure that the price paid today will generate returns in the future. This can be summarized as timing risk. For example, if we look at the stock market over the last 20 years, timing can make quite a difference in terms of returns.
To avoid being caught out by bad market timing, investors often aim to buy low and sell high. But in reality, this strategy rarely works as we’re influenced by many factors such as the news, trends, and word-of-mouth – all of which can lead us to time the market incorrectly1. Furthermore, waiting for the “perfect” time to invest can be suboptimal as it means more time that your money isn’t working. So many have turned to a different investment strategy – dollar-cost-averaging.
Risk and return: Dollar-cost-averaging vs. Lump sum investing
Dollar-cost-averaging (DCA) is an investment strategy where you make equal investments at regular intervals – regardless of the price. Not only is it an effective way to build wealth, but it’s also useful for investors who don’t prefer (or have the financial means) to make larger lump sum investments. The main benefit of a DCA strategy, however, is that it reduces an investor’s exposure to risk.
When you invest at frequent intervals, you essentially spread the risk of being caught out by bad market timing. And as timing risk lowers, so does the standard deviation of returns. For instance, when investing in stocks over 5 years, the chances of experiencing any loss can be reduced from over 90% to less than 50% through a DCA strategy2.
Implementing a DCA strategy
In the table below, you can see how a DCA strategy works when investing in stocks, for example.
As demonstrated above, the investor ends up with more shares when the price is low and fewer shares when the price is high1. And as a result, the average cost per share ends up being below the highest cost of shares1.
The same practice can be applied to other assets too such as ETFs, commodities, REITs, and alternatives. In the case of fixed-income investments such as bonds or loans, it’s the interest rate that fluctuates. Therefore, by investing at regular intervals, you can avoid making larger one-off investments when the interest rate happens to be lower.
It’s important to note that because DCA strategies reduce risk, there’s a chance of earning lower overall returns compared to lump sum strategies (where an investor may get lucky with timing). However, when the market is more volatile and the investment horizon is long, DCA strategies have been shown to outperform some lump sum strategies in terms of returns3.
The graph below demonstrates the trade-off that often exists with both of these strategies. For the lump sum strategy, both the expected return and standard deviation (risk) are higher. Whereas, with a DCA strategy, both of these factors are lower4.
Every investor can practice dollar-cost-averaging
The benefits of a DCA strategy come from the fact that investments are being spread over time – so there’s no requirement for how much money you need to invest. Therefore, you can decide on an amount that suits your financial situation and comfort level. Plus, if you’d like to get more familiar with investing in general or a new asset class, it can be a good strategy to start with before committing to larger investments.
Because you’ll be investing all year around it can also help take some of the emotional load off making investment decisions e.g. deciding on the right market timing. And once you’ve set your desired targets, it’s easy enough to make changes when needed – especially if you’re investing through automated strategies.
Making regular contributions generates growth
It’s the practice of investing plus reinvesting returns that significantly increases total returns over time1. Therefore, making regular contributions (through a DCA strategy, for example) can be a path to financial freedom. And the longer you do it for, the more your funds can grow – a concept called compound growth.
See how much your money could grow through regular contributions with our online calculator
Setting up recurring deposits
The simplest way to contribute regularly towards your investments is by setting up a recurring deposit from your bank account. This way, you don’t have to worry about actively making contributions for your chosen frequency. When investing on Mintos for example, you can set this up in a few easy steps:
- Make sure the “target amount” on your Mintos strategy or custom automated strategy is higher than the amount you have currently invested. This way, any new deposits from the recurring deposit will be automatically invested.
- Set up a standing order from your bank account and choose the amount and frequency.
- Once the standing order is confirmed with your bank, you don’t need to do anything else!
For more on setting up a recurring deposit on Mintos, you can visit our FAQs
If you’d like to learn more about investing, you can visit our Investor Academy. From beginner to advanced level topics – there’s something for everyone.
Footnotes:
- Rubin, H.W. & Spaht, C.G. (2018) Quality Dollar Cost Averaging Investing Versus Quality Index Investing | Journal of Applied Business and Economics Vol.20(6)
- Trainor, W.J. (2005) Within-horizon exposure to loss for dollar cost averaging and lump sum investing | Financial Services Review(14) 319-330
- Lu, R., Hoang, V.T. & Wong, W.-K. (2021) Do lump-sum investing strategies really outperform dollar-cost averaging strategies? | Emerald Insight
- Cho, D.D. & Kuvvet, E. (2015) Dollar-Cost Averaging: The Trade-Off Between Risk and Return | The Financial Planning Association
