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Dollar Cost Averaging

Dollar Cost Averaging

What is dollar cost averaging and how does it work?

Dollar cost averaging refers to a process where an investor allocates set amounts to specific investments at regular intervals. This will often be undertaken intentionally, by investing a lump sum of money in smaller amounts over a period of time.

Clients may also unintentionally participate in this strategy with regular super contributions, savings plans or instalment gearing.

The main aim of dollar cost averaging is not to maximise investment returns, but to minimise the risk of buying investments at the wrong time. Timing is less important with dollar cost averaging, because you have a number of purchase prices and times, rather than just one.

What is the effect of dollar cost averaging?

As mentioned above, the main effect of dollar cost averaging is minimising the risk of buying investments at the wrong price.

In reality, the financial benefit of a dollar cost averaging strategy (compared with investing in one lump sum) will depend on the performance of the investment during the strategy. This is best highlighted by a number of examples.

Example: Tim and Theresa

Both Tim and Teresa each have approximately $100,000 to invest. Tim decides that he is going to commence dollar cost averaging while Teresa decides that now is the best time to invest all of her money. Both clients invest over a 10 month period.

Market Downturn

Tim’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 10,000 8,333
February 1.15 10,000 8,695
March 1.10 10,000 9,090
April 1.05 10,000 9,523
May 1.00 10,000 10,000
June 0.95 10,000 10,526
July 0.90 10,000 11,111
August 0.85 10,000 11,764
September 0.83 10,000 12,048
October 0.84 10,000 11,904
Total in November 0.83 102,994 $85,485

Teresa’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 100,000 83,333
February 1.15 0 0
March 1.10 0 0
April 1.05 0 0
May 1.00 0 0
June 0.95 0 0
July 0.90 0 0
August 0.85 0 0
September 0.83 0 0
October 0.84 0 0
Total in November 0.83 83,333 $69,166

Upturn

Tim’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 10,000 8,333
February 1.25 10,000 8,000
March 1.30 10,000 7,692
April 1.35 10,000 7,407
May 1.40 10,000 7,142
June 1.45 10,000 6,896
July 1.43 10,000 6,993
August 1.40 10,000 7,142
September 1.40 10,000 7,142
October 1.38 10,000 7,246
Total in November 1.38 73,993 $102,110

Teresa’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 100,000 83,333
February 1.25 0 0
March 1.30 0 0
April 1.35 0 0
May 1.40 0 0
June 1.45 0 0
July 1.43 0 0
August 1.40 0 0
September 1.40 0 0
October 1.38 0 0
Total in November 1.38 83,333 $114,999

As you can see from tables above, market fluctuations can affect both dollar cost averaging and complete ownership of a managed fund by an investor.

Throughout a market downturn, dollar cost averaging can leave an investor with relatively more units than someone who has paid the highest price when investing all funds at commencement.

In contrast, during a market upturn, dollar cost averaging will leave an investor with relatively less units than someone who has paid the lowest price when investing all funds at commencement.

The important thing to note though is that in both situations, Tim has reduced the risk of a severe less on his investment by dollar cost averaging. If the market falls substantially shortly after the commencement of the strategy, Tim has the luxury of being only partially invested an able to purchase further units at the now reduced price.

We’ve looked at a market downturn and market upturn scenario, but what about situations where there are periods of volatility after which prices return to normal? The following example looks at this scenario.

Market upturn and downturn

Tim’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 10,000 8,333
February 1.30 10,000 7,692
March 1.40 10,000 7,142
April 1.45 10,000 6,896
May 1.40 10,000 7,142
June 1.15 10,000 8,695
July 1.05 10,000 10,526
August 0.95 10,000 9,523
September 1.10 10,000 9,090
October 1.20 10,000 8,333
Total in November 1.20 83,372 $100,046

Teresa’s investment over a 10 month period is as follows:

Month Purchase Price ($) Amount ($) Units Purchased per month Total Value of units
January 1.20 100,000 83,333
February 1.30 0 0
March 1.40 0 0
April 1.45 0 0
May 1.40 0 0
June 1.15 0 0
July 1.05 0 0
August 0.95 0 0
September 1.10 0 0
October 1.20 0 0
Total in November 1.20 83,333 $100,000

As you can see from tables above, Tim and Theresa’s portfolio value after prices return to normal are relatively similar.

In practice, the benefit of a dollar cost averaging strategy in this situation will depend on what happens to prices during the period of investment. As a general rule, if prices are mostly lower during the investment timeframe, dollar cost averaging will work out to be financially the better option. However, if prices rise during the investment timeframe and then fall back down, dollar cost averaging will be financially less beneficial than one lump sum investment.

Once again though, the key thing to note is that by dollar cost averaging, Tim is reducing the risk that he is buying in at the wrong price by buying in at many prices.

Summary

Dollar cost averaging is certainly a strategy that should be considered for clients who are not comfortable with full investment now due to the uncertain investment outlook.

Dollar cost averaging can be as simple as commencing a regular savings plan into a portfolio of managed funds, making regular contributions to superannuation, or moving superannuation money that is currently held in cash into appropriate longer term investment options.

Clients may also wish to consider an instalment gearing strategy, which combines the benefits of dollar cost averaging and gearing.

We greatly value our clients and are committed to honouring the trust they place in us by creating visible results for them. Get in touch to find out how we can help our clients maximize profits, minimize tax, and invest the balance for growth.

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