Examining Dollar Cost Averaging
Dollar Cost Averaging is the strategy of investing smaller regular amounts, over a longer time frame, instead of investing a lump sum in one go.
By committing to small incremental amounts, investors avoid risky decisions, such as panic buying or selling. In doing so, this removes much of the detailed work of attempting to time the market.
An example of dollar cost averaging can be seen in dividend reinvestment strategies, where dividends received are used to purchase more shares, regardless of the companies’ share price.
Also interestingly, all working Australians practice a dollar-cost averaging strategy within their superannuation accounts. Employers make contributions to each employee’s superannuation at consistent, regular amounts, regardless of the asset's price or how the markets are performing.
Dollar cost averaging is particularly useful in assisting investors to focus on their long-term investment goals, reducing the risk of volatility in their portfolios.
The Benefits
Dollar cost averaging works best for assets that have a fluctuating price, or where the price falls and rises. Investors do not need to watch the market so extensively with smaller amounts risked - creating a less is more approach.
An Example:
By using a dollar cost averaging strategy, the investor staggered the investment over a period of 6 months – and because the share price fluctuated, ended up buying 1,525 units, worth $10,156.50.
If the investor had invested $6,000 as a lump sum in the first month, they would have ended up with 750 units, worth $4,995, and made a loss on the investment.
The Disadvantages
In a rising, or bull, market environment, a dollar cost averaging strategy is not as effective; as a lump sum investment would be optimal on the day when the price was lowest.
A dollar-cost averaging investor might miss out on highs in the market due to keeping their money aside for the next regular deposit. By the time the amount is ready to be invested, the market may have continued its trajectory and the investor might have missed out on any large gains.
An Example:
During a bull market, the investor had put the full $6,000 lump sum in the first month, owning 750 units worth $11,715 by the end of the six-month period.
If the investor had used a dollar cost averaging strategy, investing $1,000 every month for six months, the investor would have ended up with 476 units worth a smaller profit total of $7,435.12.
IN coNCLUSION
Dollar cost averaging provides a straightforward and disciplined way for long term investors to accumulate wealth by minimising risk. However, this may not apply to everyone and there is no guarantee of profit performance.
For discussions on your individual investment goals please don’t hesitate to reach out to Shape Financial.