What is dollar cost averaging?

What is dollar cost averaging?

Joseph Darby

And why recent stock market troubles could be good for KiwiSaver investors

Dollar-cost averaging is a wealth-building strategy that involves investing money at regular intervals over a sustained period. It is a smart investment technique employed by investors worldwide. This is the opposite of simply investing a lump sum all at one time. Rather than trying to time the market, you buy in at a range of different price points.

If you’re a KiwiSaver member and you contribute to your account regularly through payroll, you're already practicing dollar-cost averaging.

For instance:

  • If you earn $60,000 per year and contribute 3% of your salary to a KiwiSaver Scheme, matched by another 3% from your employer. This means a total of $3,600 is flowing into your fund over the course of a year (let’s keep it simple and keep taxes out of the equation!).
  • However, it's not a lump sum – a fraction of the $3,600 is deposited every time you get paid. If you get paid fortnightly, this means that you're investing about $138 every second week into your chosen KiwiSaver Scheme. With this equal amount of money, you're buying more units of each investment fund when the price is lower and fewer units when they're more expensive. At the end of the year, you’ll get a return that’s somewhere down the middle – the average.

In the long run, this is a highly strategic way to invest.

How could recent stock market troubles due to coronavirus be good for KiwiSaver investors?

All investments rise and fall over time – this is inevitable and is referred to as market volatility. The volatility associated with investment markets is one of the major reasons some investors have been reluctant to invest in the past. However, if you follow the practice of ‘dollar-cost averaging’, the volatility risk can be diminished.

Also, as most investment markets have recently fallen in value, anyone who’s currently investing regular sums of any size is now buying the same underlying investment assets at a discounted price. One of the most successful investors in the world put it this way:

“A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.” – Warren Buffet

So, while it might feel uncomfortable to see a KiwiSaver balance drop, just remember, over the long run this is surely going to work out in your favour!

Dollar cost average - ups and downs

What about with non-KiwiSaver investments?

Dollar-cost averaging can also be used outside of KiwiSaver, such as with managed funds or by an individual investor purchasing shares.

This commonly suits many people building wealth for retirement who are still earning; for example, people with a regular fortnightly or monthly surplus from their salary or wages. You're not trying to time the market - you're simply investing a little bit over time to try to build value. Dollar-cost averaging lets you do it as your cashflow allows.

Making this strategy work does require a little discipline, as you need to keep investing a regular amount regardless of the ups and downs of the market. You need to keep your investment going through bad and good times to see the real value of dollar-cost averaging.

If you have cash available, should you dollar-cost average with a lump sum?

At some point in your life, you may have a lump sum to invest – perhaps as a result of the sale of a property or business, or perhaps an inheritance. In this case, you’re statistically better off investing it all at once. Numerous studies have proven that this is the case, with one famous study across three different major investment markets (the US, the UK, and Australia) from global investment powerhouse Vanguard stating “Finance theory and historical evidence suggest that the best way to invest this sum is all at once according to an investor’s asset allocation.” In each market that Vanguard studied, immediate investment led to greater portfolio values nearly 70% of the time. This comes down to two basic reasons:

  1. Investments typically grow in value with time (which is why people invest!). This means that there’s a high statistical chance that they’re less expensive now than in the future, and
  2. A drag on the overall investment return can be caused if holding funds in cash sitting on the side-lines.

What if you still want to dollar-cost average with a lump sum?

For anyone who still chooses the dollar-cost averaging approach for a lump sum, a disciplined approach is best. This needs to be based on two key decisions:

  1. The sum to invest each time. For example, splitting a total sum to invest of $120,000 into 12 sums of $10,000, and
  2. The total timeframe. For example, $10,000 a month for a year equals the total of $120,000.

This should ensure that cash is steadily invested while limiting the time the balance sits on the side-lines.

The bottom line

Through dollar-cost averaging, the current low prices for most investments suits those making regular contributions and will help them accumulate wealth over several years.

Dollar-cost averaging also:

  • Helps avoid trying to time the market, and
  • Doesn’t usually work with lump sums, but this can be an option for the cautious investor

To discuss this or any other investing approach, please get in touch.

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