Market volatility has investors sitting on cash wondering when to re-enter markets.

Cash levels among institutional and retail investors are at record levels as the S&P/ASX200 and technology-heavy Nasdaq Composite notch 4.6% and 24.1% losses, respectively this year.

When investors return their cash to markets, they must decide how: one bracing plunge or a series of smaller investments spaced out over time. In other words, to dollar-cost average or not?

For those on the sidelines, we revisit the age-old debate around dollar cost averaging. What is it? How does it differ from other strategies? And what do critics have to say about it?

What is dollar cost averaging?

“Dollar-cost-averaging is the notion of moving money into securities slowly over time rather than all at once,” according to Morningstar’s Christine Benz.

Assume an investor receives $5,000 from an inheritance or tax return. They want to invest in Telstra shares and have two options: Invest the full sum in one go or spread it out over several months or years. The method echoes logic familiar to the many investors who set aside a portion of a pay to invest.

Dollar cost averagers argue buying shares over a regular period of time circumvents the issue of picking highs and lows in the market; investors buy in at an average price for the stock. In cases where markets are trending lower, dollar cost averaging also spreads losses out.

The piecemeal approach also encourages investors to commit to regular purchases and avoid the agonies of market timing.

“Dollar-cost averaging can help investors overcome some of the psychological impediments that can bedevil investors, especially the difficulty of staying disciplined with their investment programs in tough markets,” says Benz.

Dollar cost averaging Tesla shares

Let's look at a worked example using Tesla shares.

Telsa peaked at US$1229.91 on 4 November last year and has steadily declined since. With dollar cost averaging, an investor who bought $10,000 worth of Tesla in monthly increments of $2,000 starting in January would have paid an average of $997 per share. Cheaper than lump sum investments in January or April, but more expensive than purchases in February, March or May.

What do critics say?

As the Tesla example shows, timing is key to the success of dollar cost averaging. When markets fall, those using the strategy minimise losses. However, piecemeal purchases mean investors miss returns when markets are rising.

Detractors argue markets rise more often than they fall and therefore dollar cost averagers miss out on potential earnings more than they dodge potential losses.

A 2012 study from Vanguard showed that over the average 10-year time frame, dollar cost averaging underperformed lump sum investing nine out of 10 times. Morningstar research in 2019 arrived at a similar conclusion.

Even someone investing a lump sum on the eve of the Global Financial Crisis still outperformed a dollar-cost averaged portfolio ten years later, according to report authors Maciej Kowara and Pau Kaplan.

“If returns are generally positive, you're better off having more dollars working for you instead of holding them back to invest over time,” says Morningstar’s Amy Arnott. “Statistically speaking, the market goes up more often than it goes down, so keeping money off to the side usually doesn't help.”

Ultimately, human psychology matters too. Where investing large sums at once makes someone more likely to delay investing or sell at the wrong time, dollar cost averaging may be more suitable.

“However, if dipping a few toes in the water at a time is the only way you can ease yourself back into the pool, it's better than just sitting on dry land forever,” says Arnott.