So far in this series we’ve looked at risk and return, diversification, why we use fund managers and today we look at dollar cost averaging and market timing. Dollar cost averaging will be the subject of this article and we’ve added a separate article on market timing.
Understanding the concept of investment units
Many people have heard of the concept of dollar cost averaging, but we find that many people don’t fully understand how it works.
When you invest into a managed fund, you buy a number of units in the fund. If you invest $100 and the units are $1 each, you buy 100 units. Over time, as the underlying investments grow in value, the value of the units increase.
If the fund increased by 10% and had the same number of investment units, you’d still have 100 units, but they’d now be valued at $1.10 each.
Conversely, if the fund’s value decreased by 10%, your investment would only be worth $90. You’d still hold 100 units, but they’d now be worth $0.90.
Dollar cost averaging
Many people don’t have large lump sums to invest, but they do have the capacity to save small amounts regularly. They may not realise it, but they are dollar cost averaging!
Let’s say you invest a fixed amount of $100 per month over 6 months. The table below shows how many units you’ll purchase each month, based on some market fluctuations.
| Month | Amount Invested | Unit Price | Number of Units Bought | Total Number of Units |
| 1 | $100 | $1.00 | 100 | 100 |
| 2 | $100 | $0.95 | 105 | 205 |
| 3 | $100 | $0.90 | 111 | 316 |
| 4 | $100 | $0.85 | 117 | 433 |
| 5 | $100 | $0.90 | 111 | 544 |
| 6 | $100 | $0.95 | 105 | 649 |
| Total | $600 | Average Price = $0.925 | 649 |
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In the example above, we’ve assumed the investment declines in value from a unit price of $1.00 to $0.85 and then appreciates again to $0.95.
Can you see how when the unit price decreases you buy more units with your $100? When the units only cost 85c each, you buy 17 more than when they’re $1 each.
But importantly, let’s look at what’s happened to the value of your investment. You’ve invested a total of $600. The fund has declined by 5% (from $1 per unit to $0.95 per unit) but your investment has actually increased.
You now have 649 units valued at 95c each – a total value of $616. How did this happen? You bought units cheaply and they’ve since increased in value.
Over the long term you’d expect the unit price to increase beyond the $1 price you started at. Whilst a decline in unit prices is upsetting, it does provide you with an opportunity to buy at lower prices.
It’s like shopping
Imagine if you go shopping and see your favourite dessert for sale at 50% off. You’re faced with a couple of choices – buy one at half price, or buy two for the price of one.
It’s a bit like that with investments. If you’re optimistic about the long term outlook for your chosen investment strategy, then any price declines provide you with an opportunity to buy more at cheaper prices.
When to dollar cost average
Historically share markets have negative years every five or six years. On average they rise more often than they fall. So, if you have a lump sum to invest, statistically you’re better off investing it at once rather than in instalments.
However, for many people we suggest a gradual investing of their lump sum, perhaps over 6 to 12 months. It all depends on their objectives, the current market conditions and the level of risk they’re prepared to accept. Everyone is different and there is no single right answer.
Action Steps
Dollar cost averaging provides a means to smooth out the effects of market volatility. Even if the value of your investment declines in the short term, you can have some satisfaction knowing that you’re buying investments every month at a low price.
If you’re considering investing now, but are concerned about the market conditions, please speak with us and we can provide some advice that suits your specific needs and objectives.
Now that you’ve finished reading this article, have a look at today’s second article on market timing.
Photo Credit Jackerome
Important information
This letter contains financial product advice of a general nature only and is not intended to constitute personal advice. It does not take into account your particular investment objectives, financial situation or needs. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in the publication.
Financial Wisdom Advisers are Authorised Representatives of Financial Wisdom Limited ABN 70 006 646 108, AFSL 231138, a wholly owned but non-guaranteed subsidiary of Commonwealth Bank of Australia ABN 48 123 123 124.
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