What is dollar-cost averaging? Let’s say you’ve got $100,000 to invest in shares but you’re nervous about the market.

What if the doomsayers are correct and we’re heading for further economic and market woes? You can ignore the risks and put your $100,000 in now; keep the money in cash and wait until you’re sure the outlook is OK (which could mean keeping it in cash indefinitely); or you could compromise and invest your $100,000 over, say, 10 months with contributions of $10,000 each month.

The third strategy is dollar-cost averaging. It can be done through either regular saving (super is a great example, as a percentage of your salary is invested regularly without you having to do anything about it) or drip-feeding a lump sum into investment markets.

Instead of putting all of your investment money in at once (and risking the chance that the market might tank tomorrow), you average out your entry price so that your overall return is more likely to reflect that of average market returns.

So how does it work? Think of it as a strategy where you automatically buy more when investments are cheap and less when they’re overvalued. To take a very simple example, assume you want to invest $1000 a month in a share fund. The units are currently valued at $1 each so you buy 1000 units this month. By April, the market has risen 20 per cent. Your $1000 will buy 833 units. In May, the doomsayers are proven correct and the market crashes by 50 per cent. Your $1000 will now buy 1667 units in the share fund.

So you have 3500 units worth $2100 - a loss of 30 per cent on your investment. If you had invested the full $3000 in the beginning, however, you would have only 3000 units worth $1800 - a loss of 40 per cent.

If the market recovered a further 50 per cent in June, units in the share fund would be back to 90¢. After buying another 1111 units, you’d have 4611 units worth $4150 - a 3.75 per cent gain on the $4000 you had invested. But if you had invested the full $4000 in the beginning, your 4000 units would be worth just $3600 - a loss of 10 per cent.

Dollar-cost averaging is most advantageous at market peaks as it shields you from the risk of putting all your money in at the wrong time. However it can reduce your return when markets are rising. If you had received a lump sum in early March last year, for example, you would have been much better off investing it immediately than drip-feeding it into the market.

In a recent briefing, NAB Private Wealth said critics argued that because share prices historically rose more often than they fell, investors using dollar-cost averaging were likely to pay higher average prices than investors who jumped in boots and all.

However, this argument overlooks human psychology. Most investors are reluctant to put money into shares when the outlook is grim but happy to do so when prices are high. Instead of investing their lump sum last March, for example, many investors would have kept it in cash and missed out on part or all of the upturn.

How do I use dollar-cost averaging? Bailey says it works best with long-term regular savings such as super, as the process is automatic and your portfolio has time to benefit from buying more units or shares when prices are low. Setting up an automatic regular savings plan also avoids the temptation to try to second-guess the market by postponing regular investments when prices are falling and catching up later when the market looks more promising.

You can set up regular savings plans outside super but NAB warns it could involve higher transaction costs than investing a single larger amount and may be more complicated to track and implement. If you’re considering using dollar-cost averaging to get back into the sharemarket, NAB says studies suggest shorter periods (six to 12 months) to become fully invested give better returns than longer periods.

Reference: Sydney Morning Herald.