With the S&P/ASX200 down -8.24% over one year, it doesn’t take a crystal ball to conclude that the bottom may not be too far away.
Trouble is without a bellringer to call the bottom, a lot of investors risk missing out on most of the early gains when markets finally start moving.
History suggests that when market do finally move, they move sharply, and by being sidelined, even for only a few days, means potentially missing on a lot of the upside.
One way to buy stocks when markets are either highly volatile or on a downward trend, without feeling like you’ve got you bum in the breeze, is to deploy what’s called dollar cost averaging (DCA).
Far from being rocket science, DCA is the art of making regular incremental investments over a period of time as opposed to a one-off lump sum investment.
It reduces the market timing risk of investing your entire portfolio in a single transaction on what might be an expensive entry point.
What you’re effectively doing via a DCA strategy is spreading out (averaging) your investment entry points to achieve a lower average cost base and reducing the impact of volatility.
But remember, a DCA strategy is less effective in a rising or bull market environment and Vanguard research concludes that Australian investors achieve better returns investing as a lump sum 66% of the time.
That’s hardly surprising given that markets typically to go up most of the time.
Assuming markets are rising, you can typically lock-in a lump sum at the lowest price, in the expectation that momentum will continue to drive the share price forward.
A DCA strategy can backfire when markets go up by eroding your potential profit.
However, within a down market, a DCA strategy allows you to buy more shares/units when the price falls in any given month, and fewer when the price is higher.
Whether you realise it or not, you’re already deploying a DCA strategy by default every time your employer makes compulsory super contributions on your behalf.
Beyond super, there’s nothing to stop you applying the same strategy to shares and there are many EFT, managed funds, and micro-investing (AKA fractional trading) options that also allow you to add small amounts at regular intervals.
For younger investors, a DCA strategy also means putting what funds you have to work in the market, rather than waiting until you’ve amassed a larger lump-sum in the hope of buying higher priced blue-chip stocks.
While a DCA strategy can help to lessen short-term market volatility, it’s important to remember that it won’t protect investments from sustained market declines or the collapse of an individual stock.
This is why a DCA strategy complements an ETF that tracks a diversified index or a basket of stocks, rather than using it to buy one particular stock.
The table below shows how someone who invests $200 every month for five months will pay different amounts for each unit as the market price changes.
Over the whole period of five months the average cost per unit was $7.37 so not the lowest or the highest price that the units cost during that time.
The table also shows the best and worst cases achieved if the total purchase was made all at one time instead of being spread out.
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