Dollar cost averaging

Is meltdown really imminent?

Firstly, it’s important to recognise that there’s always at least one economist predicting imminent share market meltdown. The reality is that your portfolio will decrease in value on average once every 5 years. But will there be a meltdown this month? This year? This decade? No one actually knows and you can miss out on a lot of growth if you sell up in anticipation.

When invariably another global meltdown (also called a ‘dip’, ‘drop’, or ‘correction’) does happen, it’s even more important to keep your head. Remember the headlines from the 2008 Global Financial Crisis? Mass panic, lost fortunes?

Well it turns out not everyone lost money. In fact, most of the people who lost money were those who panic sold their shares on the way down. 10 years on and that crazy, terrifying drop-to-end-all-drops now just looks like a blip

S&P 500 Historical Prices

‍

We’ll keep saying it: plan, plan, plan

We’re not saying don’t take action when the share markets drop. Your plan may well include:

• Having a price in mind that your shares might drop to. If they drop to that price, you sell them to minimise your losses
• Having a peak price your shares may get to, if they hit that price, you sell some or all of them to recoup your initial investment. Then leave the rest and ride the wave.
• Not signing into any brokerage account when you know the share markets are going through a rough patch - you can ignore your portfolio for as long as you feel you need to
• Dollar cost averaging your investments

Trying to time the market can be like playing the lottery

Yes, we know, we know. Yesterday, we talked about Value and Growth investing. Let’s recap:

Value investing: Analysing and investing in companies that you’ve determined are currently undervalued.
Growth investing: Using your understanding of a company or industry to find areas of potential high growth in the future.

Rule seven: Don’t bother trying to beat the share markets.

Sure, taking advantage of opportunities can work if you're consistently good at it, however if you're new and don't have proven strategies, it might not be wise to try and 'time' the market. Instead of obsessively checking your shares and buying and selling based on your theory of what will happen in the future, you could have a lot more success (and spare time) by simply investing in quality companies and riding out the fluctuations.

Only psychics can pick the future

All those investing experts we keep talking about spend a lot of time making predictions about what will happen in the future. They use their knowledge of share market cycles, mega trends, interest rates and a bunch of other fancy financial forecasting tools to guess what will happen in the share markets in the short, medium and long term.

But, at the end of the day, an educated guess is still just a guess. Sometimes they get it right, sometimes they don’t. Ever been caught in the rain on a day that was supposed to be sunny? Well, predicting the weather is a much more exact science than economic forecasting. The simple truth is that there's no way to know reliably when the price of an asset is at its lowest, or when it will go down even further.

Enter: Dollar cost averaging

Dollar cost averaging means investing a fixed amount of money in the same company or ETF at regular intervals over a long period of time. Ignore the short term fluctuations in share prices and just keep putting that same amount in regardless.

Each time you invest in a company, the price for an individual share will be different – sometimes higher, sometimes lower – so the same dollar amount will get you a different total number of shares. The goal is to avoid investing all your money when the shares are priced too high so that you get more bang for your buck over time.

It’s very simple and very effective, which is probably why it's a popular way to start small and slowly, with the aim of building wealth over time.

Working with the market works better than trying to beat it

In the long run, this is a highly strategic way to invest. Because you buy more shares when the cost is low, you reduce the average price you pay for shares.

Let’s look at someone who invests $200 every month in a hypothetical ETF:

Over the 5 months, the average share price was $49.20 (add the monthly prices and divide by 5), but because their monthly $200 bought more shares when the share price was lower, the average price our investor paid was $48.31 (divide the $1,000 they invested by the 20.698 shares they own). By investing a fixed dollar amount every month, rather than buying a fixed amount of shares every month, they have effectively ‘beat’ the market.

But wouldn’t it have been better to buy all their shares in month 1 or 4?

Yes. But in month 3, when the share price was $51 (up from $40 then $50), they could also have thought the share prices were rising and invested then.

Repeat the mantra: You may win when you time the market, but it's also likely you will lose.

The benefit of dollar cost averaging is that it is set and forget

You should regularly review your plan and make sure you are still comfortable with it. During those reviews, you may identify companies or ETFs that you no longer have any faith in (e.g an ETF that invested entirely in DVD rental companies). In those cases, there is a good argument to accept your losses, sell up and put whatever remains of your investment money into something you do see a future in.

But what about another financial crisis? What about global meltdown?

During big crashes like 2008, the numbers look terrifying. On paper, you can watch your shares plummet in value by 20% or 80%. But the reality is, you haven’t actually lost any real money. As we have learned, the only way to do that is when you sell your shares.

Contrary to what your gut may say as you watch your shares drop in value, dollar cost averaging actually has the potential to be massively beneficial during the dark days of the share markets. Why? Because the prices are so low, your regular investment buys you more shares than it does when prices are high. This means you’ll have more shares in your portfolio increasing in value when the markets go back up.

You’re probably already using a dollar cost averaging strategy!

If you’re putting money into KiwiSaver every pay day, you are dollar cost averaging your KiwiSaver contributions.

If you have ever looked into your fund, you’ll see the value goes up and down over time, which means the price of one ‘unit’ (‘share’ in the fund) changes too.

Because of the unit price changes, every pay day, your contribution buys a different amount of ‘units’ in the fund. Some paydays, you’ll buy more, others, you’ll buy less.

KiwiSaver is actually a great example of a passive set-and-forget investment strategy. You pick your provider, you set up regular contributions, and you basically ignore it until you retire. Over that time, it will have gone up and down in value thousands of times, but most people don’t even notice!