Trading on the share market is widely regarded as being motivated by two powerful human emotions; fear and greed.
In recent weeks, share market volatility has many investors fearful and compelled some to sell off their investments. More often than not, basing investment decisions on emotions and following the herd tends to be a poor course of action. It’s a poor move because it crystallises what may be just a temporary loss and runs the risk that you could miss out on any rebound or recovery in share prices.
Attempting to time the market in this way is rarely successful. An alternative approach to investing is a practice known as dollar cost averaging. Dollar cost averaging can remove the fear and emotion from investing as it works like a regular savings plan, the difference being that rather than making a regular cash deposit into a bank account, make a regular contribution into investments held in the share market.
Dollar cost averaging can be an attractive investment strategy for those who are new to investing on the share market as it can help to reduce the overall volatility risk of your portfolio and maximise its long term growth by smoothing out the market’s ups and downs.
How does it work?
Dollar cost averaging involves investing a set amount of money on a regular basis over a long period of time. This could be an investment in a specific stock, managed fund or an index fund. Consider the following example. Say you put $100 per month into a managed investment that had an initial unit price of $10. Over the next few months, the market falls (causing the unit price to drop) before recovering to its original value.
|
Month |
Investment |
Unit Price |
Units Purchased |
|
1 |
$100 |
$10 |
10.0 |
|
2 |
$100 |
$8 |
12.5 |
|
3 |
$100 |
$5 |
20.0 |
|
4 |
$100 |
$8 |
12.5 |
|
5 |
$100 |
$10 |
10.0 |
|
Total |
$500 |
|
65 |
At the end of 5 months, you have 65 units each worth $10, so you have $650. You only invested $500, so your profit is $150 even though the unit price is the same as when you first invested.
Had you invested a lump sum of $500 at the beginning of month 1, you would still only have $500 at the end of month 5. So even though the market declined during the 5 month period, you were better off investing small amounts over regular intervals rather than attempting to time the market by investing a lump sum when things looked rosy.
Of course, dollar cost averaging doesn’t guarantee a profit. But with a sensible and long term investment approach, dollar cost averaging can smooth out the market’s ups and downs and reduce the risk of investing in volatile markets.
Getting started with a Dollar Cost Averaging Strategy
The first step in planning a dollar cost averaging strategy is to decide how much you can realistically afford to invest over an extended period of time. The next step is to establish an appropriate investment vehicle as it’s important to consider how diversification may further reduce risk. By combining a dollar cost averaging strategy with a diversified a portfolio, an investor can maximise the profit potential and minimise risk. Remember that you need to stay with this investment strategy for many years in order for it to be effective. The aim is to remain committed to this investment strategy over the medium to long term and to not allow short term fluctuations in price to influence your buying strategy. As always, before making any decisions about an investment strategy for your needs, it’s important to seek professional advice. Please contact your financial adviser for further information.
Source: Capstone. Published: 14 September 2015
