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.