Reducing Human Nature Risk By Using Dollar Cost Averaging
“Save little save often – dollar cost averaging works, if you stick to it “
(Paul Clitheroe – ‘Ten Key Steps to Wealth’, Penguin, 2002)
How we humans react
The current investment environment is still dominated by negative sentiment. It continues to be fuelled by economic uncertainty, threats of terrorism, and of course what the cabbie told us this morning. Accordingly, the bankruptcy-promoting concept of “Fear and Greed” continues to be consciously mismanaged by most of us. That is, we continue to buy at the top, and sell at the bottom. Oddly, but understandably, Fear more so than Greed is currently the dominant emotion. However, is now when we need some Greed, albeit disciplined Greed? Should we consider buying at the bottom for a change? Now that equity markets are as close to “the bottom” as they probably have been in three years, it is probably fair to suggest that markets are less risky than they have been.
Dollar Cost Averaging….the discipline and the tool
As Paul Clitheroe so succinctly suggests, Dollar Cost Averaging, when carried out in a disciplined fashion over an extended period of time, “ ensures that you buy fewer shares when the price is high, and more when the price is low.” [Source: ’10 key steps to wealth’, Penguin, 2002.]
Dollar Cost Averaging is ‘the process whereby a set amount is allocated to specific investments at regular intervals. This is intended to have the effect of lowering the average price paid for the investments.’
[Source: The Australian Investors’ Dictionary]
Disclaimer: Information included herein including any expression of opinion or forecast has been obtained from or is based on sources believed by us to be reliable, but is not guaranteed as to accuracy or completeness. The information is given without obligation and on the understanding that any person who acts upon it or changes his or her position in reliance thereon does so entirely at his or her own risk.
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How can Dollar Cost Averaging benefit investment returns and reduce human risk?
Consider the following example of two rational people who each invest the same amount of money into a managed fund over the same time period. Investor A attempts to time the market (investing in January over two successive years), Investor B Dollar Cost Averages. Investor A invests $1000 and decides to invest $1200 in January of each year. Investor B invests $1000 and decides to invest $100 each month.
Investment Month January February March April May June July August September October November December January TOTAL INVESTED TOTAL VALUE
Investor A $1,000
Units Purchased 100.0
Investor B $1,000 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $2200 $2,381
Why not here? Why not here? Why not here? Why not here? Why not here?
$1200 $2200 $2,200
120.0 220.0
Units Purchased 100.0 10.5 11.4 11.6 11.8 12.5 13.2 12.5 11.8 11.6 11.4 10.5 10.0 238.8
Unit Price $10.0 $9.50 $8.75 $8.65 $8.45 $8.00 $7.60 $8.00 $8.45 $8.65 $8.75 $9.50 $10.00 $10.00
The table shows that Investor B is $181 or 8.2% better off than Investor A ($2381 - $2200 = $181) over the period by using the power of Dollar Cost Averaging. Moreover, Investor B has only needed to make a single disciplined decision regardless of markets going up or down. His decision is that he Dollar Cost Averages over the full period in question. (i.e January to January) Conversely, Investor A has had to be clever enough to “market time” his second investment in January of the second year. This is a random decision, driven possibly by nothing more than Greed. If Fear and Greed didn’t influence Investor A, and he was in fact a brilliant market timer, a better result for Investor A would have been to invest his $1200 in either May, June, July, August or September. Had Investor A invested his $1200 in any of these months, his final investment result would have been better than that of Investor B. To achieve this outcome, Investor A needed to be both a brilliant market timer and to overcome the undoubtedly prevailing emotion of Fear associated when the markets were probably still falling. Could you have picked the optimum time and then actually invested? Be honest with yourself.
Disclaimer: Information included herein including any expression of opinion or forecast has been obtained from or is based on sources believed by us to be reliable, but is not guaranteed as to accuracy or completeness. The information is given without obligation and on the understanding that any person who acts upon it or changes his or her position in reliance thereon does so entirely at his or her own risk.
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How does Dollar Cost Averaging fit into an investment portfolio?
Investing a fixed amount each month helps reduce the volatility of a portfolio and maximises long-term growth by systematically buying the same dollar amount of a managed investment each month. Potential investment returns are at their greatest when equity markets decline and investor confidence is at its most negative. The importance of this concept should not be discounted.
High profile researcher Stephen van Eyk agrees with this principle and stated recently that……
‘in the 13 years to July 2002, missing the 10 best days in the market cost 127% in performance over the period. You simply can’t say “I’ll buy back in later after the market recovers,” particularly in an environment likely to feature lower, rather than higher, stock market returns over the decade.’ In a falling share market environment, the greatest risk is not necessarily investing; the risk is more likely to be not investing.
Has there ever been a better time to harness the power of Dollar Cost Averaging than right now? Possibly…..however,
The expectation of a globally co-ordinated economic response should signal a move to an underlying improvement in world economic fundamentals. In a recent paper, Stephen van Eyk suggested that, ‘In Australia dollar terms, international equity markets are now around 40% below the peak levels of March 2000. This setback to prices plus the expectation of a profits recovery has returned the sector to attractive valuation levels……….within international equities, we recommend a strong overweight to growth stocks, which have recorded huge price drops (60%-70%) as economic conditions deteriorated in the past few years.’ Disciplined Investing (through Dollar Cost Averaging) in managed funds that focus specifically on superior quality companies increases the probability of higher returns over time. History reveals many examples of share markets experiencing sharp declines (creating opportunities for the disciplined investor) only to recover, and go on to greater heights – perhaps now is one of those opportunities? Speak to your financial planner……
“Take care of the pence, for the pounds will take care of themselves…” (Lord Chesterfield, 1747)
Another in adam’s series of ‘Investor Insights’.
Disclaimer: Information included herein including any expression of opinion or forecast has been obtained from or is based on sources believed by us to be reliable, but is not guaranteed as to accuracy or completeness. The information is given without obligation and on the understanding that any person who acts upon it or changes his or her position in reliance thereon does so entirely at his or her own risk.
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