The reality of dollar cost averaging!
One concept that has dominated the financial services industry for decades is the notion of dollar cost averaging.
According to industry experts, dollar cost averaging can reduce the risk of investing in volatile markets and help avoid the ‘so called’ pitfalls associated with ‘timing’ your entry into market.
The concept involves placing small deposits into a particular investment at regular intervals over a period of time, regardless of whether the market is moving up or down, so as to average the price at which you purchase the asset.
Let's see how it works.
Dollar cost averaging in a rising market
Let’s say you put $200 per month into a managed fund that initially had a unit price of $20. Over the next few months, the market falls (causing the unit price to drop), before recovering to its original value.
| Month | Contribution | Unit Price | |
|---|---|---|---|
| 1 | $200 | $20 | 10 |
| 2 | $200 | $16 | 12.5 |
| 3 | $200 | $10 | 20 |
| 4 | $200 | $16 | 12.5 |
| 5 | $200 | $20 | 10 |
| Total | $1,000 | 65.00 |
At the end of the five months you have 65 units, each worth $20, so you have $1,300. Given that you invested $1,000, your unrealised profit is $300 - even though at the end the unit price is the same as when you first invested.
Dollar cost averaging in a falling market
Obviously the example above demonstrates a positive outcome but what if we reversed this example to show what happens when the market rises and then falls back to its original value. Again, we will use the example of investing $200 per month in a managed fund with a unit price of $20
| Month | Contribution | Unit Price | |
|---|---|---|---|
| 1 | $200 | $20 | 10 |
| 2 | $200 | $24 | 8.33 |
| 3 | $200 | $30 | 6.66 |
| 4 | $200 | $24 | 8.33 |
| 5 | $200 | $20 | 10 |
| Total | $1,000 | 43.33 |
In this instance, while we still invested $1,000 over five months, we are now in a loss because we only have 43.33 units at $20 which equates to $866.67. Imagine if you used dollar cost averaging in a market that continued to trend down over several months? We obviously don’t need to say anymore!
The real issue with this strategy is the inability of the industry to ‘time’ the market; consequently, investors are encouraged to invest smaller amounts over long periods of time to take advantage of the fluctuations in the market.
In our opinion, this strategy is flawed because not only has the investor lost the opportunity to invest their funds in assets that are rising in value, they are taking higher risks investing in assets that are potentially falling in value with no guarantee of making a profit, which is ludicrous in anyone’s book.
To learn more about our philosophy to investing and how we can support you to profit from the stock market through our individually managed accounts, click here.
