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Dollar Cost Averaging - the Key to Investing in Uncertain Times

by Mark Causer

With the current volatility in global markets i.e. US taper, economic uncertainty coming out of the Ukraine, European interest rates dropping below zero to stimulate growth, continued media hype of a China slowdown, Iron Ore price concerns, Australians working out how to deal with the Budget changes (if passed) etc etc, many investors, both young and old, seem to be making nervous decisions. In some cases, and probably worse still, many are simply NOT making any decisions, remaining in low interest cash investments - retreating to the sidelines if you like 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.

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 and time the market, they risk missing its best performing cycles - even the most experienced investment fund managers cannot predict the market movements.

One strategy that investors can consider is that of Dollar Cost Averaging (DCA). This strategy is definitely not a new strategy, but one that is often disregarded as it is not a quick road to riches strategy!

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. The significance of this is that when the individual investor invests into the market and achieves an average cost per unit that is less than the average price per unit, then the investor has acquired their investment at a discount to the rest of the market - on average they have payed less than other investors which could result in greater future profits.

We never question the monthly loan repayment that we must repay – why shouldn’t the same ‘payment’ discipline be applied when we make investments!

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.

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

Month Unit Price No. of Units Purchased
January $20 25 units
February $17 29.41 units
March $15 33.33 units
April $13 38.46 units
May $12 41.66 units
June $12 41.66 units

With $3000 invested, Tony now owns 209.52 units - the average cost is $14.32. This compares to an average unit price of $14.83.

How does Tony benefit?

DCA cannot shield against a potential loss when the market declines, however it can help reduce the loss. Assuming Tony purchased $3000 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's assume Tony purchases $500 per month in a rising market;

Month Unit Price No. of Units Purchased
July $12 41.66 units
August $12 41.66 units
September $14 35.71 units
October $16 31.25 units
November $18 27.77 units
December $22 22.72 units

In the rising market example, Tony's average cost per unit is $14.94, which is less than the average unit price of $15.66 for the period. This example suggests is that in both a rising and falling market, Tony has paid less on average for his units than the market average - DCA has worked!

Of course, in hindsight, Tony 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, Tony 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 Tony 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.

Generally speaking, many investors discounted the DCA strategy once the GFC had started i.e. selling low, but unfortunately didn’t anticipate the material and quick recovery, which saw many investors buying back into the market after new rises of 30% – 40%. I would suggest that if their investment portfolio was sufficiently diverse into quality investments, their financial position would be much better today.

Is there a more complex form of DCA?

Yes. Dollar value averaging (DVA), involves adding to your investment portfolio so that the portfolio BALANCE increases by a set amount, regardless of market fluctuations. As a result, when the market falls, you contribute more but when it rises, you contribute less. In contrast to dollar cost averaging (fixed amount at each fixed period), with DVA you can even NOT invest in some markets.

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. 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 a somewhat an ‘automatic pilot’ mechanism to say invest $1000 a month to go 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 10 month period, instead of investing into the market in one go. It means if the market falls by 10 per cent, you don’t see $5000 disappear in one go.

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 $500K 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 of imposing a discipline into building a portfolio for your retirement.

It is also important that whichever strategy suits your needs, investors must still continue to monitor their portfolios (in conjunction with their 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.

 

June 26, 2014
 
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