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DCA - THE KEY TO INVESTING IN UNCERTAIN TIMES

by Mark Causer

With the current volatility in global markets, many investors are making nervous decisions and selling their growth investments for cash. Like others, they are retreating to the sidelines and are merely watching and taking no action. Both of these strategies can potentially be damaging financially, because a declining market may well offer investment opportunities.

The Lucky Country

On the other hand, other investors stop buying when markets climb - their concern being that they are paying too much for their investments! As always, when investors try to time the market, they risk missing its best performing cycles - even the most experienced investment fund managers cannot predict market movements.

One strategy that investors can consider is that of Dollar Cost Averaging (DCA).

DCA sees the investor making regular investments of a specific dollar amount under a specific periodical basis. These automatic investment plans continue to invest regardless of the financial market swings and gyrations. This strategy when executed correctly can drive down the average cost per unit. By staggering their investment in a disciplined way, the investor can acquire their investments at a discount to the rest of the market. Consequently, on average they will have payed less than other investors, which will result in greater future profits.

DCA can be an effective way to pursue future financial goals in that it gives investments time to grow. The example below shows how the strategy works over six months, investing the same amount of money.

Mark invests $500 per month for six months - In this example, the market declines steadily;

 

$3,000 invested and Mark now owns 209.52 units - the average cost is $14.32. The average unit price for the same period was $14.83!

How does Mark benefit?

DCA cannot shield against a potential loss when the market declines, however it can help reduce the loss. Assuming Mark purchased $3,000 of units in January, he would have only acquired 150 units and the value of his portfolio at the end of June would have been $1,800 or a paper loss of $1,200!

Now let us assume Mark purchases $500 per month in a rising market;

In the rising market example, Mark’s average cost is $13.77, which is less than the average unit price of $14.00 for the period. This example suggests that in both a rising and falling market, Mark has paid less on average for his units than the market average - DCA has worked!

Of course, in hindsight, Mark would have made more money had he invested the full $3,000 at the beginning of the period when the unit price was at its lowest. However, as markets are inherently volatile, Mark couldn’t have predicted that the market would rise steadily during the period to December. So the advantage of using DCA in this example is that it allows Mark to profit as the market rises while still providing some downside protection.

Is DCA right for everyone?

Many investors have used this strategy successfully, however DCA is not designed to produce sudden, dramatic profits, but to generate sustained growth over the longer term, despite the fact there may be short-term fluctuations in the market. This strategy also requires discipline, to keep investing when the market falls and then the resistance to sell when the market rises again.

Is there a more complex form of DCA?

Yes. Dollar value averaging (DVA) involves building and adding to your investment portfolio (of say direct equities or index) so that the number of shares or units held increases by a set amount each month, regardless of market price fluctuations. As a result, when the price falls, you invest more but when it rises, you invest less. For example, say you bought 10 BHP shares for $50 in 2011. In 2012, you plan to invest $500 per month for the following 12 months. Therefore, you would then lay out “value” targets throughout the year as follows.

 

At the end of the month, you assess the current value of the portfolio and compare it to the targets above. For example, if at the end of January, the portfolio is worth $900, you would then contribute $600 instead of $500 in order to force yourself to buy more shares when the market goes down. Then, at the end of February, the market has gone up a lot and we find that the value of the portfolio is $1,800. Given that this value is over your target, you would then invest nothing in BHP, instead place the investment money into another investment you had considered or cash / fixed income.

For some, DVA is more suited over dollar cost averaging because when a market falls and shares become more attractive at lower prices you actually buy a lot more shares. On the other hand, when share prices rise and are relatively less attractive you buy less or none at all. This method is a little more complicated than dollar cost averaging as you have to do the maths. Many investors prefer dollar cost averaging because it is an automatic pilot mechanism to invest say $1,000 a month into buying shares.

What I like about this method is that instead of investing a sum of money all at once, you allocate it over time. So, for example, if at the beginning of the year you had $50,000 you wanted to invest in stocks, you might invest $10,000 every two months over a year instead of plonking your money into the market in one go. It means if the market falls by 10 per cent, you do not see $5,000 disappear.

With DVA you work out your money goal and then you do a bit of work to make it happen. The goal might be based on a 10 per cent return a year and then you have to invest each month to achieve that goal i.e. invest a little more when the market value drops and a little less when market value rises.

In a nutshell, you might nominate a goal of $500,000 in 20 years time and using a return of say 10 per cent a year you have to increase your investment in bad years when you miss 10 per cent but you can ease up in good years.

Both DCA and DVA are good ideas for imposing a discipline into building a portfolio for your retirement.

It is also important that whichever strategy suits your needs, you must still continue to monitor your portfolio (in conjunction with your Financial Keys Adviser). It may well be that the chosen investment(s) simply are not capable of delivering the required performance, even in a strong market. Of course, your investment objectives may also change which may give rise to adjusting your investment strategy.

 

 

November 1, 2011
 
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