By Tim Hewson
30 April 2008
Investment markets generally trend up (bull market), down (bear market) or traverse sideways.
In a bull market, investors are typically driven by greed and don't give much thought to important long-term investment objectives, as long as they continue to make money.
In contrast, during a bear market investors are normally fuelled by fear, uncertainty, second-guessing and occasionally stupidity.
So typically they become conservative, retreat from the market, bide their time and sit on the side lines - waiting for someone to switch on the light at the end of the tunnel so they can re-enter.
What you miss when you sit it out
It's virtually impossible to pick the exact point in a market cycle, the day or price when a bear turns to a bull market. In most cases, it takes months before the market's sentiment changes.
As a result, investors typically sit on the sideline for too long, missing the opportunity to maximise potential gains.
Others fear re-entering the market too early and the thought of possibility suffering short-term losses. In either case, by waiting too long or entering the market at the wrong time in a cycle, you typically miss being able to take advantage of market volatility.
Investing - the four main rules
1. Investing is a long term exercise and requires a clear investment strategy, understanding of your risk tolerance and persistence - nobody consistently makes money overnight;
2. Diversify;
3. It's time in the market, not timing the market that counts; and finally
4. Nobody makes money sitting on the sidelines.
Dollar Cost Averaging - tailor made for volatile times
Dollar Cost Averaging is a very simple technique as it allows investors to -
Diversify their portfolio;
Reduce the risk of making a single lump sum investment;
Take advantage of volatile market conditions; and
Avoid the issues associated with market timing.
Put simply, dollar cost averaging allows you to invest long-term and provides a means of reducing risk during uncertain times.
The actual method involves making small, but regular investments over a longer period. More units are purchased when the price decreases and fewer when the price increases. Over the long-term, the average price obtained is generally lower than making a lump sum investment upfront, or at a future point in time.
Dollar Cost Averaging - how does it work?
Strategic Stephanie invests $1,000 a month for twelve months, whilst Impatient Ian makes a single, lump sum investment of $12,000 into the same fund and in month one.
Strategic Stephanie
Time Unit Price Investment Units
Month 1 $10.00 $1,000.00 100.00
Month 2 $9.00 $1,000.00 111.11
Month 3 $8.00 $1,000.00 125.00
Month 4 $7.00 $1,000.00 142.86
Month 5 $6.00 $1,000.00 166.67
Month 6 $5.00 $1,000.00 200.00
Month 7 $ 6.00 $1,000.00 166.67
Month 8 $7.00 $1,000.00 142.86
Month 9 $8.00 $1,000.00 125.00
Month 10 $9.00 $1,000.00 111.11
Month 11 $10.00 $1,000.00 100.00
Month 12 $11.00 $1,000.00 90.91
Total $8.00 $12,000.00 1582.18
Impatient Ian
Time Unit Price Investment Units
Month 1 $10.00 $12,000.00 1200.00
Month 2 $9.00 0.00
Month 3 $8.00 0.00
Month 4 $7.00 0.00
Month 5 $6.00 0.00
Month 6 $5.00 0.00
Month 7 $6.00 0.00
Month 8 $7.00 0.00
Month 9 $8.00 0.00
Month 10 $9.00 0.00
Month 11 $10.00 0.00
Month 12 $11.00 0.00
Total $10.00 $12,000.00 1200.00
After 12 months
In month 12 Unit Price Investment Units Value Growth Return
Stephanie $11.00 $12,000.00 1582.18 $17,403.97 $5,403.97 45%
Ian $11.00 $12,000.00 1200.00 $13,200.00 $1,200.00 10%
*Please note that this is an example only and is not based on real unit prices of any funds. It does not take into consideration any entry or ongoing fees or your individual financial circumstances, the impact of taxation or changes to the cost of units. This example should not be relied on for the purposes of making a decision in relation to a financial product.
Although both Stephanie and Ian invested the same amount into the same fund, the results after twelve months are remarkably different. By making smaller, regular investments over a longer period, Stephanie paid a lower average unit price - only $8 compared to Ian's $10.
Stephanie also received more units than Ian because her average unit price was lower than Ian's. As a result, Stephanie obtained greater growth over the 12 months and also received a return four and a half times greater.
Dollar cost averaging - the advantages
One of dollar cost averaging's great benefits is that it encourages a long-term, disciplined approach to developing your investment strategy.
It also means you won't have to wait until you have saved enough to make a larger investment, as you can start investing smaller amounts straight away - remember nobody ever got rich by simply watching the market.
Importantly, setting a budget and establishing objectives upfront typically ensures that investors make an informed decision, suitable to their risk profile.
The greatest potential for maximising profit occurs when you invest in a trough and sell at the peak. So, the sooner you enter, the greater the opportunity you will have to improve your portfolio's long-term performance during volatile periods.
And whilst timing peaks and troughs is virtually impossible, dollar cost averaging will often provide the best opportunity to transition your investment between bear and bull markets. Helping your portfolio better weather sustained periods of volatile price movement.
Dollar cost averaging is also another form of diversification (in this case the purchase price and timing of the investment). It also serves as a cost effective way of gaining and increasing exposure to various investments.
With managed funds you also get the additional benefit of the diversified portfolio being managed by a team of investment professionals, who are active in the market everyday.
Remember, during a falling or bear market, the greatest risk of all is not investing - and not being able to take advantage of the transition to a bull market.
Dollar cost averaging - the disadvantages
It has to be said that dollar cost averaging doesn't guarantee better returns.
For example if you pick the market inflection point and invest at the beginning of a bull market, you will generally be better off making a single, lump sum investment as you'll see the maximum benefit of growth from day one.
However, it's worth keeping in mind the risks associated with market timing and getting it wrong.
Unfortunately, dollar cost averaging doesn't work on larger investments like direct property, which due to its high barriers to entry prevents you from making smaller on-going investments.
So before considering dollar cost averaging, ensure that it's also appropriate for the investment type, and importantly that it's accompanied by a sound investment strategy.
And remember, dollar cost averaging doesn't guarantee you profit. It only works on the assumption that the market eventually recovers over a period of time. So the importance of selecting the right investment becomes increasingly important.
Don't suffer from investor paralysis
So don't let the market's current volatility leave you standing on the sidelines. Instead consider using this opportunity to identify suitable investments and seize the opportunity to use this simple risk diversification technique. Check out our new online dollar cost averaging demonstration to see how it works during different market periods, or enter your own prices to come up with your own market scenarios.
If you want further information on how to implement dollar cost averaging with RaboPlus, or want to learn more about how parcel trading can help you to better manage potential capital gains tax, check out the RaboPlus Regular Investor Plan for more information.
Thanks for reading.
Happy investing!