If you’re an investor considering entering the market with your hard-earned savings you may feel a little uneasy about placing a large lump sum into the market all at once. Especially when you think it could experience an extended period of market volatility.
It’s quite normal for investors to be cautious about investing large amounts, especially where they have a negative view of the short-term direction of the market and anticipate price volatility.
Regardless of your investment goals or whether you expect to invest for a short or long term, overcoming your apprehension about lump sum investment can be difficult.
What’s good to know is that there is another way which allows you to both invest in the market and potentially take advantage of any volatility that occurs while you are investing.
An investment strategy which drips feeds regular payments into the market, known as ‘dollar cost averaging’, is a great way to reduce the potential risk of investment and overcome those investor nerves.
The concept behind ‘dollar cost averaging’ is to spread the risk of investing your capital across a number of regular payments into a specifically constructed portfolio.
By spreading the investment across multiple payments, you are reducing the risk of immediate loss to your portfolio if the market falls just after investing.
If the market is volatile, rising and falling in value frequently, then you may benefit from this volatility. If you buy in when the market price is slightly lower or cheaper, it means you can buy more shares for your money.
Over an extended period of time, this can provide varying levels of capital growth whilst helping to guard against potentially large losses.
Most employees in Australia are currently already doing a form of dollar cost averaging within their super funds.
When your employer makes the mandatory superannuation guarantee contributions, these payments are used to purchase shares in your super fund's portfolio.
These purchases are usually done on a monthly or quarterly basis thereby dollar cost averaging between four to 12 times a year.
The real power of regular investment is that it can help lower your average purchase price per share. This provides you with the opportunity to earn greater returns from your investment even if the share price doesn’t technically go up.
Regular investing, dollar cost averaging, may be best explained with an example.
If you have $60,000 to invest and were happy to take up to six months to enter a market which is currently experiencing moderate levels of volatility, then you could split the investment into equal instalments. Therefore by investing say $10,000 per month into a share with a price fluctuating around the $1 mark, the average price and units purchased could be calculated as follows.
|MONTH||INVESTMENT ($)||SHARE PRICE $||SHARES PURCHASED|
|Total Units Purchased||62,806|
|Average Purchases Price||0.9553|
|Value at end where share price -=$1.00||$62,806|
|Unrealised Capital Gain||$2,806|
This example illustrates the potential investment gain even where the price begins and ends at the same value of $1 per share.
In comparison, we can look at the potential gain or loss from investing the full $60,000 at different time frames during the same period.
The start of the period where prices were at $1 per share, the best period where prices were $0.87 per share and the worst period where prices were $1.10 per share.
The table below shows the results and compares this with the dollar cost averaging example above.
|SHARE PRICE $||$1.00||$0.87||$1.10|
|VALUE AT END @$1 PER SHARE||$60,000||$68,966||$54,545|
|POTENTIAL UNREALISED GAIN / LOSS||$0.00||$8,966||-$5,454|
|POTENTIAL GAIN / LOSS VS DCA||$2,806||$6,160||-$8,260|
What’s important to remember is that dollar cost averaging is most effective in a downward or volatile market, where the portfolio invested in has a long-term expectation for growth.
When the market is experiencing high levels of growth, rising stock prices, then this strategy is not as successful as a lump sum investment strategy.
The challenge then becomes looking at short and medium term market and economic factors for indications of where the investment markets may be trending, to know how and when to invest.
Your personal tolerance for investment risk also needs to be taken into account. This will help to direct both the investment strategy you use to invest your hard earned savings, as well as the type of assets you will choose to include in your portfolio.
With any longer-term investing it is important to consider time in the market and how long you’re investing for, rather than trying to time the market, picking a time to buy low and sell high.
When considering your options for investment it is important to remember that your personal circumstances, income and capital needs, and investment objectives can have a significant impact on the strategies you implement. Every investor's circumstances are different.
Take the time to discuss your options with an investment professional who can assess your situation and provide you with the advice appropriate to you.
FOR MORE INFORMATION ON DOLLAR COST AVERAGING
An RSM Investment Specialist can help you review your current circumstances, investment objectives and tolerance to investment risk and determine a plan that is specifically designed for you. You can book a Free Financial Health Check with an RSM Specialist by clicking here.