Dollar cost averaging is a technique to reduce risk by investing funds gradually over time rather than in one lump sum. For example, if an investor decides to invest an inheritance of $100,000 into Australian shares, she could decide to invest $2,778 per month over 36 months using a low cost, non-commission paying share index fund.
Spreading the investing of a lump sum over time reduces the risk of being caught out by a large market correction. In our example, if there was a large share market correction in 18 months, the investor would only have invested half of her funds. The other half would continue to be invested monthly at the lower share prices. Investing a fixed dollar amount each month means more shares are bought when share prices drop and less shares are bought when share prices increase. At the end of the investment program, $100,000 would be invested at the average share price over three years.
Dollar cost averaging also removes emotion from the investing decision. It is a disciplined approach which accepts that it is very difficult to pick when it is a good time to buy or sell shares. The answer to the question of whether it is a good time to buy then becomes:
"I don't know, but I do know shares are a good long-term investment so I'm always buying them once a month."
Dollar cost averaging is also very easy to implement. A three-year investment program can be set up by filling out an application form then arranging a monthly BPAY via internet banking.
Even the world's most famous investor, Warren Buffet, thinks dollar cost averaging beats his own investment vehicle, Berkshire Hathaway:
"We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund -- where you don't put the money in at one time, but average in over 10 years -- you'll do better than 90% of people who start investing at the same time."