What is dollar-cost averaging?
What is dollar-cost averaging?
The stock market and other investment markets change in value every day, which can make it daunting to invest.
There are so many different opinions out there from market commentators, the so-called “bulls” and “bears”, about whether assets are overpriced, it is easy to be paralysed and do nothing.
Thankfully, there is a proven strategy which can help to mitigate the risk of investing at the wrong time, so you can start investing and harnessing the long-term benefits.
Dollar-cost averaging is a strategy where you invest the same dollar amount into the same stock or fund at regular intervals.
This interval can be whatever you choose, but is typically weekly, monthly, or quarterly.
How dollar-cost averaging works:
Let’s say you decide to invest $500 into a fund that tracks the All Ordinaries Index, on the first day of every month.
That means you’re buying $500 worth, 12 times a year.
Every time you buy, the price of units in the fund will vary because the market fluctuates.
So the number of shares that you get for your $500 will also vary.
When the All Ordinaries is high, your $500 gets you fewer units, and when the All Ordinaries is low, your $500 will get you more units.
When the market is high, you buy less units, and when it is low, you buy more units, so it is counter-cyclical.
This is similar to being at the supermarket and seeing that strawberries are on sale, so you buy more strawberries. But if they are more expensive, you buy less.
Unfortunately, when it comes to the stock market, most people end up doing the exact opposite.
Right after a big drop in the market, when it’s actually the cheapest time to buy stocks, most people don’t buy anything because it seems too risky, and many people do the complete opposite and sell.
Almost all of us are guilty of this if we have investments. As much as we like to think that we’re rational human beings when it comes to our money, we are driven to a large extent by our emotions.
So the number one reason why dollar-cost averaging is effective is because it protects us from our own emotions.
Why does it work?
Dollar-cost averaging is effective for three reasons.
As discussed, it takes emotion out of the equation. When it comes to investing, your emotions are your worst enemy. The best time to buy in the market is also going to be the scariest time to buy. If you bought during the GFC, or during the height of the fears over the COVID-19 epidemic, you would be well ahead now. It is obvious in hindsight, but at the time, we were just as scared as everyone else and didn’t put any money into the market. So if you invest according to your emotions, you’ll end up chasing the market and getting nowhere. But with dollar-cost averaging, you invest like a robot no matter what, and this results in your average entry price improving automatically over time.
You money has no downtime. Almost all of your investable money is invested at all times. Instead of parking your money in a bank account, while you’re waiting for a better time to buy, most of the money you accumulate is working for you in stocks or bonds day in and day out. And when your money is working for you in your investment, you’re participating in all the dividends, and all the growth that gets compounded over time. People who decide not to do dollar cost averaging and instead wait for a better time to buy, risk having their money sit in a bank account earning nothing for a long period. This ends up reducing their returns over time.
Dollar-cost averaging is actually doable. Unlike a strategy that requires you to time the market perfectly, dollar cost averaging is realistic. Most people have what it takes to implement a dollar cost averaging strategy.
So how do you do dollar cost averaging?
The first step is to identify a mutual fund that you would like to invest in. This could be a stockmarket index fund, or another kind of mutual fund such as Firstmac’s High Livez fund, which invests in Residential Mortgage-backed Securities. It is important to make sure that you select a mutual fund, rather than an Exchange-Traded Fund (ETF) because ETFs don’t allow you to make automatic recurring purchases. You could do it manually, but that defeats the purpose because you will still have to make a decision each month.
All investments pose a degree of risk so if you are unsure, seek the advice of an independent financial professional.
With mutual funds, once you have bought into it (typically with a $5000 minimum), you can set it up so that your money will automatically buy more shares or units every month. For instance, with High Livez, you can set up a regular direct debit with a $1000 minimum. Then you can sit back, let it run.
Dollar-cost averaging is boring, it doesn’t make for exciting discussion like timing the market, and you will never be regarded as an investment genius who timed the market right with a big punt when everyone else was wrong.
But it works as a way to slowly but surely build wealth. It also takes a weight off your mind, as you don’t need to obsess about when to invest, whether to invest, or how much to invest, which can all cause mental fatigue.
Then you can put your time and energy into the other things in your life that you want to do!