dollar cost averaging

Dollar cost averaging describes the practice of investing a fixed amount at regular intervals.. It may help take some of the risk out of investing in fluctuating markets by removing timing risk.

Timing Risk is the risk you take when you try to enter or leave the market at exactly the "right" time. You may get it wrong. If you hear about a great opportunity, and buy in, the market may turn sour and drop quickly. At which point you believe you have made a mistake and so sell out of the investment, only to hear that the market improved immediately after you have left. Buying at the top and selling at the bottom is what happens in timing risk.

So how does dollar cost averaging help? Well, realising you cannot control the market is a wise move. Therefore, dollar cost averaging tries to take advantage of the market especially if it is volatile and up one day and down the next. Sound familiar??

This is the ASX 200 share market over the last 12 months.

Strategy

Here is the scene!!

Let us pretend, you have $2,400 to invest into a share fund. How will you invest the money? (We are cheating just a little because we know ahead of time how the market is going to perform in this imaginary example.) The graph on the right shows the movement of the unit price over the 12 months of investing.

Notice how the price is 50 cents in January and after a volatile year, ends at 53 cents. At least there is a little profit.

Method 1.

One way to invest is to take the full amount and invest the $2,400 into the fund in January, then hang on tight for the wild ride ahead.

Since, the unit price is 50 cents each, the $2,400 investment buys 4,800 units and when the year is ended each unit is worth 53 cents.

This makes the investment now worth 53 cents x 4,800 units or $2,544.00

This is a profit of $144.00 and represents a gain of 6%.

Method 2.

Dollar cost averaging would break the $2,400 up into 12 deposits of $200 each. So throughout the year you would make a $200 purchase of units each month and you would buy the units at whatever price the market happens to be.

The blue table shows the market unit price and the number of units purchased with the $200.

At year end you have accumulated 5,437.62 units and each one is valued at December's price of 53 cents. This makes the investment worth 53 cents X 5,437.62 units = $2,881.94.

This is a profit of $481.94 which represents a gain of 20.08%.

In both scenes above, the same amount was invested over the same time and it was only the timing that was altered and in this story made a significant improvement on return.

Is it guaranteed?

Does dollar cost averaging always work?? No, it does not. The reason why this strategy is profitable is due to a "down" market. A time when prices are more down and struggling than up and growing.

However, if the unit prices were at times shaky but mostly increasing in value, then this strategy may not work and you may profit more by investing everything up front.

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