Dollar Cost Averaging is a simple investment approach that turns short term volatility to the regular investor’s advantage. In effect, it shows that the reason many investors are reluctant to enter, or remain in, a falling or volatile market is the very reason they should consider doing so.
If you are making regular contributions into KiwiSaver for example, or a Managed Funds portfolio, share portfolio, even crypto, you are taking advantage of a little-known strategy called Dollar Cost Averaging. This could be your new best friend in the investment space!
There really is a way to turn market volatility and time into a powerful wealth creation vehicle. Right now is when we should be learning about and speaking about these things as we’ve just been through, and are going through a very volatile time in the markets. This is not something to feel uneasy about, this is something to embrace, and Dollar Cost Averaging is the key to doing so. If this little trick can help you ‘stay the course’ through these current uneasy market conditions, then we’ve really achieved something haven’t we!
How does it work?
Dollar Cost Averaging is simply investing a set amount on a regular basis, regardless of market movements. Think your KiwiSaver contributions for example. You’re not waiting on certain market conditions, you’re simply investing in regular intervals, regardless of what’s going on out there. When the market falls, prices drop, and you acquire more units for your money. When the market rises, prices rise, and you acquire fewer units for your money.
The result over time is that the average price you pay per unit is reduced. It also means that when the unit price is high, your investment is worth more and when the price is low, you can buy units more cheaply.
If you contribute $100 per month buying units valued at $10 into a consistently rising market over a ten-year period, you will attain a decent return. However, investment markets generally experience growth in spasmodic spurts rather than as a consistently upward appreciation in value. And in these circumstances can generate a greater return for you.
Why the greater return?
Because each time the market dropped, you bought more units for your same level of contribution. At the end of the tenth year you have more units valued at $10 than in the first example, so providing a greater total value.
Falling then Rising Market
If the market drops sharply and then rises to its original value over the ten-year period, the same principle applies but with possibly more dramatic results. In fact, uncertainty creates opportunity. The wise investor recognises that short-term market dips can contribute to longer term investment gains.
When does Dollar Cost Averaging work best?
Dollar Cost Averaging is most effective with investments that tend to fluctuate in value over the short term and when the markets themselves are volatile. The more volatile the investment, the more rewarding Dollar Cost Averaging will be for the investor. KiwiSaver or Managed Funds that invest in shares or property are good examples of more volatile types of investments.
Dollar Cost Averaging is not a short-term tool.
The success of Dollar Cost Averaging over the long term is based on the assumption that upon withdrawing your investment, the total value of your investment is greater than the average unit price at which you acquired units.
Short term peaks and troughs are characteristic of most markets but over time, economic fundamentals will generally dominate. So, remaining invested over time will help to ensure that you fully reap the benefits of this effective investment technique.
‘Stay the course’ in other words!
However, what Dollar Cost Averaging will not do for you is act as a substitute for the fundamental rules for successful investing: maintaining a diversified portfolio, being comfortable with your portfolio’s level of risk, adopting a realistic time horizon and having the discipline to stay invested, even when, temporarily, the odds seem to be against you.
It’s the time spent invested not the timing that counts.
Contrary to what many people believe, it is the time spent invested in the market not the timing of an investment that counts, and over the longer term, investing in equities has produced far superior returns than, say, leaving your money in the bank.
Let’s take a snapshot of the markets from say 1961 through to 2001. Over those 40 years, the average annual rate of return from NZ equities was 13.7% per annum. Over that same period of time, the average annual rate of return from 90-Day Bank Bills was 9.3% per annum.
So, what does this mean in real terms?
Take an example of an investor saving a regular amount of $100 per quarter from December 1961 through to November 2001.
Equities would have amassed: $657,700
Bank deposits would have amassed: $169,600
Lost Earnings? $488,100
Assuming different start dates since 1961 (i.e. quarterly onwards), the only periods where an investor would have been worse off in equities rather than cash were if they had started investing between December 1982 and September 1985 (a period of high interest rates), or if they had started investing on or after 1995. This growth in value takes into account all major market events such as October 1987, the 1990 Gulf War and September 11 2001. In other words, with very few exceptions, the longer you invest, the more likely you are to achieve returns in excess of those you would have received from bank term deposits.
Or look at it another way. The longer you invest in equities, the fewer the periods you are exposed to in which you would have suffered a loss and the greater the probability that your returns will be positive.
Remember this very powerful advice, mentioned already in this article:
It’s about TIME IN the markets, not TIMING the markets!
Stay the course, reap the rewards. Invest in all seasons, and take advantage of this wonderful strategy known as Dollar Cost Averaging.
Power to the people!
Daniel Carney
Goodlife Financial Advice