A new dawn for dollar-cost averaging
14 July 2020 | Investment principles
As global equity markets fell more than 30 per cent over February and March, many investors were buying in.
But, contrary to what you may be thinking, they weren't necessarily trying to time the markets to make short-term profits as share prices see-sawed.
There was certainly plenty of day trading activity going on, with trading volumes breaking new records as speculators piled in to downtrodden stocks hoping for a quick turnaround.
Yet a large part of the activity was also fuelled by other types of investors who are always buying, irrespective of what the markets are doing.
For them it was business as usual, because they adhere to a tried and tested incremental investment method known as dollar-cost averaging.
What is dollar-cost averaging?
Dollar-cost averaging may be an unfamiliar term to some, but if you're a member of a managed superannuation fund you're actually already doing it (indirectly) via the regular concessional contributions being made by your employer.
Each time your compulsory Superannuation Guarantee contributions are credited to your account they are invested by your super fund into managed funds including ETFs, direct shares, bonds and other assets, depending on your selected product investment strategy.
Because the fund is buying assets for you at different times, and share and unit prices are likely to be lower or higher from the date that your last regular super contribution was invested, your asset purchasing power will have either increased or decreased.
Similar to a regular savings plan, dollar-cost averaging simply involves investing the same amount of money at set intervals over a long period – whether market prices are up or down.
Investors practising dollar-cost averaging automatically buy more shares or units when prices are lower and fewer when prices are higher. Over the total period that you keep investing, your average entry cost into specific assets will potentially be lower than the prevailing market price.
In the low-tax super context, employees can easily magnify the potential effectiveness of dollar-cost averaging through higher salary-sacrificed contributions.
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.
It's particularly useful in assisting 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 markets.
Putting dollar-cost averaging into practice
Incremental investing is gaining popularity, especially through online platforms that enable to individuals to invest automatically on a regular basis.
The easiest way to illustrate incremental investing and its application to a dollar-cost averaging strategy is to calculate how investment balances can build up over time, using a combination of regular contributions, reinvestments of distributions, and compounding returns.
The table below is based on a starting amount of $5,000 and set weekly contributions over a 10-year period, with an average annual return of 6 per cent including distributions.
|Weekly contributions amount||Balance after 10 years|
Source: Vanguard Investments
By allocating set amounts towards investing, and assuming returns will vary widely over a 10-year period in line with market conditions, an investor would have a regular flow of funds to direct into investments at different market prices.
The use of dollar-cost averaging does not necessarily mean investments will succeed, and nor does it protect investors from falling asset prices.
However, there is definite value in countering the emotion normally associated with investing by adopting a systematic incremental investment approach based on the principles of asset allocation and diversification.
Dollar-cost averaging provides a straightforward way for most investors to steadily accumulate wealth without being overly concerned by prevailing market volatility.
For those with long-term horizons with the discipline and resolve to keep investing, even during the most volatile investment periods as we've been experiencing, it's a strategy worth exploring.
An iteration of this article was first published in The Australian on 6 July 2020.
Personal Finance Writer