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Worried about volatility, dollar cost averaging key in choppy markets
By following a simple practice known as dollar-cost averaging to buy shares or managed funds, investors can build holdings in assets in a non-emotional and disciplined way. Moreover, it may make good sense when share markets are falling, though it doesn’t work as well when prices are rising, according to some experts.
Dollar cost averaging involves investing a set amount of money at regular intervals. By investing this way you are not attempting to pick the lows or highs of the market as you might do with a lump sum investment, but rather investing a fixed dollar amount regardless of the direction of markets.
For example, a total of $120,000 could be divided into 12 equal amounts of $10,000 to invest each month over a year irrespective of how markets perform. In contrast, with lump-sum investing, an investment of $10,000 would be made at one point.
So which investing strategy wins out?
Robin Bowerman, principal, market strategy and communications at Vanguard Australia, says over the long term, markets generally go up, so on that basis the best day to invest is the full amount at a single point in time and let it run.
“A Vanguard research paper found that, given certain assumptions, investing a big lump sum all at once had a better chance of producing higher long-term returns than drip-feeding the money into the market using dollar-cost averaging. This finding was based on historic long-term returns from share and bond in Australia, US and UK. As the paper emphasises, investment of a lump sum gains exposure to the markets as soon as possible,” he says.
However, dollar-cost averaging does makes sense in another key way: it keeps investors in the market in a non-emotional way.
“For most investors without a huge windfall to invest, a critical role of dollar-cost averaging is to help keep us focused on the long-term in a disciplined, non-emotional way. “It is one of investment’s emotional circuit breakers,” says Bowerman.
In addition, dollar-cost averaging may address concerns of a risk-averse investor about investing a big sum into the market immediately before a possible sharp fall in prices. “It is a way for such an investor to ease their way into the markets,” he says.
Indeed, dollar cost averaging could be a particularly suitable for investors now given the current state of financial markets and falling prices.
According to MLC Financial Planning’s Understanding Investment Concepts – Dollar Cost Averaging document, dollar-cost averaging makes sense when markets are falling. “This is because only a fraction of the total amount to be invested is exposed to declines in the market.
“Also, when the market price falls, your regular investment amount will purchase more investment shares or units, and providing a sound savings regime and ideal investment strategy for people with a regular income but without large sums to invest,” the paper says.
However, when market prices are trending upwards, a lump-sum purchase of assets will do better than if those shares were bought using dollar cost averaging. “This is because the full gain on the price rise is captured by the full amount of money invested up front.”
According to consumer finance website, moneychimp.com, the conclusion is the same. You can do the analysis yourself and experiment over different time periods with their calculator, which uses historical US market data over several years to let you compare dollar-cost averaging with lump-sum investing for the start date you specify.
Under most circumstances, the lump-sum investment beats the installment method. Each strategy wins at least some of the time, but after a few runs you’ll see that dollar-cost averaging is the statistical ‘dog’, losing about two times out of three.”
According to moneychimp.com, dollar cost averaging will only win if your start date falls right before a dramatic crash or at the start of a 12-month slump. “But unless you can predict these downturns ahead of time, you have no scientific reason to believe that dollar-cost averaging will give you an advantage.”
However, according to moneychimp.com, dollar cost averaging does have a psychological appeal: “if the market dips, people will be happy because dollar-cost averaging will be saving them money; and if the market goes up, people will be happy regardless.”
