Paul's Insights: An investment strategy that's anything but average
One of the questions I’m most asked right now, is how I am personally investing given the current market volatility.
I’m sure people are looking for tips around market timing. But no market timer that I know gets their timing consistently right. That’s because nobody has yet worked out how to read the future. That said, I do have a handy tip: Try dollar cost averaging.
Let me explain. It’s pretty obvious that you should buy when things are cheap and sell when they are expensive. It’s delightfully simple. But guess what most investors do? When the news is good and investments are expensive, they buy. When the news is bad and investments fall in value, they sell. It’s an instinctive response. However, it’s also recipe for financial ruin.
For me, dollar cost averaging makes things very easy. Here’s how it works. You just decide how much you want to invest every month, six months, or yearly – it really doesn’t matter. Then, just stick to your strategy regardless of what markets are doing.
We’ll imagine for example, that you invest $1,000 each month into a particular share. The share price, like all listed assets, will rise and fall over time. This is what could happen. On 1 January 2020 when our hypothetical share was trading for $1, you purchased 1,000 shares. In early February 2020, when the share was trading for $1.20 your $1,000 investment bought 833 shares. In March 2020, when the ETF was trading for $0.80 you purchased 1,250 shares.
Let’s look at the results. You bought the most shares in March 2020 when our imaginary share was trading for 80 cents. When did you buy the least? In February, when the share price was $1.20. This shows how dollar cost averaging forces you to buy more when assets are cheap, and buy less when they are expensive. It’s a discipline worth using.
Dollar cost averaging means you don’t have to relentlessly follow the news cycle trying to pick the ‘right’ time to invest. And unless you are a cross between Nostradamus and Albert Einstein, the likelihood of being able to pull off such a staggering feat all the time is about nil.
Punting on trying to move in and out of investment markets at ‘optimal’ times is a mug’s game. The maths is against you. You’d need to be right with your timing the vast majority of the time simply to break even. It’s just too difficult.
That’s why I have always followed dollar cost averaging, steadily drip-feeding cash into investments on a regular basis. Not only am I keeping costs low, I’m also free to enjoy life without wasting precious time trying to second-guess the market.
Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.
Frequently Asked Questions about this Article…
Dollar cost averaging is an investment strategy where you invest a fixed amount of money at regular intervals, regardless of market conditions. This approach helps you buy more shares when prices are low and fewer shares when prices are high, averaging out the cost over time.
Dollar cost averaging is recommended because it simplifies investing by removing the need to time the market. It helps investors avoid the emotional pitfalls of buying high and selling low, and allows them to steadily build their investment portfolio over time.
During market volatility, dollar cost averaging allows you to continue investing without worrying about market timing. By consistently investing, you can take advantage of lower prices during downturns, which can lead to better long-term returns.
Yes, dollar cost averaging can reduce investment risk by spreading out your purchases over time. This minimizes the impact of short-term market fluctuations and reduces the risk of making large investments at unfavorable times.
Market timing is generally not a viable strategy for everyday investors because it requires accurately predicting market movements, which is extremely difficult. Dollar cost averaging is a more reliable approach as it doesn't rely on timing the market.
The frequency of investing with dollar cost averaging can vary based on your preference and financial situation. Common intervals include monthly, quarterly, or yearly. The key is to remain consistent with your chosen schedule.
By not following the news cycle for investment decisions, you can avoid the stress and emotional reactions that often lead to poor investment choices. Dollar cost averaging allows you to focus on long-term growth without being swayed by short-term market noise.
Paul Clitheroe is the Chairman of InvestSMART and the Australian Government Financial Literacy Board. He is also the chief commentator for Money Magazine, providing insights and guidance on investment strategies and financial literacy.