Dollar-cost averaging: An investor's emotional circuit breaker
16 April 2018 | Investment principles
The latest bout of higher sharemarket volatility reinforces the potential benefits of a disciplined investment strategy called dollar-cost averaging. It can act as an investor’s emotional circuit breaker and a means to progressively create long-term wealth.
Dollar-cost averaging simply involves investing the same amount of money into, say, shares or managed funds at regular intervals over a long period – whether market prices are up or down.
Investors practising dollar-cost averaging automatically buy more, shares or units in a managed fund when prices are lower and fewer when prices are higher. This averages the purchase prices over the total period that an investor keeps investing.
Yet the central attribute of dollar-cost averaging is not so much the price paid for securities; it is the adherence to a disciplined, non-emotional approach to investing that is not distracted by prevailing market sentiment.
Dollar-cost averaging can assist investors to focus on their long-term goals with an appropriately diversified portfolio while avoiding emotionally driven decisions to buy or sell – in other words, trying to time the market. Repeated research, including by Vanguard, shows that market-timers rarely succeed over time.
Of course, the use of dollar-cost averaging does not necessarily mean that investments will succeed; nor does it protect investors from falling asset prices.
Super fund members having contributions regularly paid into their diversified super accounts are practising a form of dollar-cost averaging and employees can easily magnify the potential effectiveness of dollar-cost averaging through higher salary-sacrificed contributions.
Most investors use dollar-cost averaging as a way to regularly save a proportion of their incomes. However, investors can sometimes face the issue of how and when to invest a large, one-off lump sum – perhaps from an inheritance or sale of an investment property. Should such a large amount be invested all at once or drip-fed into the markets using dollar-cost averaging?
The answer to this question should, of course, take into account personal circumstances such tolerance to risk, age and how long the capital is likely to remain invested.
A Vanguard research paper published several years ago confirmed that investing a sizeable lump sum all at once generally had a better chance of producing higher long-term returns than drip-feeding the money into the markets. This research was based on long-term past returns.
As this research paper comments: “Clearly if markets are trending upward, it’s logical to implement a strategic asset allocation as soon as possible because it should offer a higher long-run expected return than cash.”
And investing a lump sum immediately maximises the rewards of compounding, as earnings are made on past earnings as well as the original capital.
Yet risk-averse investors with a large amount of capital to invest may understandably want to ease their way into the markets in an effort to reduce the impact of a possible sudden fall in prices.
Putting aside the issue of how to invest lump sums, dollar-cost averaging provides a straightforward way for most investors to steadily accumulate wealth without being overly concerned by prevailing market volatility.
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.