Dollar Cost Averaging
How Regular Savings Create Gains From A Falling Market
Dollar Cost Averaging is a strategy in which an investor places a fixed dollar amount (or indeed any other currency) into a given investment such as a unit trust, on a regular basis. The investment generally takes place each and every month regardless of what is occurring in the financial markets. As a result, when the price of a given investment rises, the investor will be able to purchase fewer units. When the price declines, the investor will be able to purchase more units.
Millions of investors around the world employ a dollar cost averaging strategy because it offers the following benefits:
- It’s an attractive option for investors who want to contribute to their investment portfolios on a regular basis.
- It eliminates the issue of ‘market timing.’ As a result, an investor’s returns will be determined more by the overall trend in a given fund as opposed to the investor’s specific entry price. In addition, it helps investors reduce their cost basis on securities that decline in value.
You decide to invest $1000 per month into two funds. During the first 12 months, Fund A shows steady growth at 2% per month. Fund B falls by over 30% in the first few months, recovering back to the initial level by month 12. In which fund will you have accumulated your greatest investment value?
The answer might be surprising. Take a look at the figures:
In summary, over 12 months, Fund B has delivered better than twice the returns of Fund A in percentage terms!
Notes about Dollar Cost Averaging:
- The Dollar Cost Averaging strategy for reducing market risk relies on (i) you having a suitable time horizon for your investments, and (ii) your chosen fund recovering from the decline and returning to the upward trend. In the example above, if you needed access to your funds when Fund B is low, you will make a loss on surrender.
- Dollar Cost Averaging reduces market timing risks for volatile investments and is a reason why regular savings plans are so popular for building long term financial security. The example above could be twelve years rather than twelve months, but the concept and outcome holds true.
- Dollar Cost Averaging can be appropriate when considering higher-risk investments such as emerging market funds, if the investor anticipates a positive overall trend in the medium to long term.