Severe share market downturns can certainly knock the wind from the sails of the most hardened in- vestor. Most of us will view such events not as an opportunity, but rather as a pretty strong warning to get out and don’t come back! And rightly so, I say, having experienced many such events during my time as an adviser.
Who could forget the severe market volatility experienced during the GFC which continued through subsequent years? Relentless market underperformance during this time certainly destroyed the ma- jority of value that had built up very nicely over the proceeding five years. A grim period indeed, and one that any investor wishes to never happen again – well not in their investing lifetime anyway!
But as always seems to happen, markets do recover from what was believed to be a knockout punch. And sure enough, returned back money that had so quickly been evaporated. Sadly, human nature being what it is, meant we stood on the sidelines and watched it all happen. Oh well, at least we promised ourselves to be ready the next time it happens!
Fear and greed will always be intrinsic elements of investment markets and as such we tend to act accordingly to whichever one is prevailing at the time. One ready-made solution to smooth out both market volatility and the accompanying emotional roller-coaster is termed dollar cost averaging (DCA).
Dollar Cost Averaging – one answer
Quite simply DCA is investing a fixed dollar amount on a regular schedule rather than in one lump sum. Your focus is the accumulation of assets on a regular basis, rather than trying to pick the best time to invest.
This habitual buying takes full advantage of market fluctuations as your allocated monthly invest- ment amount buys more or less depending on prevailing prices. It is then a simple matter to calcu- late an average buy price over say a 12 month period.
With dollar cost averaging, you take a lot of the emotion and fear out of investing because where the market goes in the short-term is far less important to you, as long as you stick to a regular invest- ment plan. If an event hits the economy and your investment falls in value, don’t panic, you just end up buying more shares at a lower price.
Dollar Cost Averaging isn’t perfect
But, just like smoking, it can have its drawbacks! Overall, critics of dollar cost averaging will usually argue that the efficacy of a single lump sum investment will provide greater returns over the long term which they ably support with some pretty convincing empirical research.
But I for one, don’t believe that the lump sum method helps a nervous investor emotionally enough to equip them for any severe volatility. Having the market take a sudden nosedive, just after you
have deposited your inheritance in an index ETF will send shivers down the most hardened investor.
Should the downturn continue for any length of time it usually means time to bail out for most in- vestors. As a result, your investment objective of accumulating assets is now forgotten.
Specifically, though, a DCA strategy is probably not suited to every investment vehicle. Be very care- ful of using it for single share investments unless your research is both detailed and ongoing. More often than not, companies take some time to display a deterioration of their business model within their share price.
Add to this, general market gyrations and any ‘loser’s’ become hard to spot. It is also a good idea to rethink any dividend reinvestment plans regularly. In the corporate world, things change, and not always for the best.
Managed Fund or ETF?
A good way of deploying the DCA strategy is through a managed fund or index ETF. Monthly depos- its (especially MF) are obviously simple to achieve and usually without cost. Additionally, automating the process keep’s you at arm’s length from the decision to invest.
This reduces the chance of irrational actions when you get the old ‘nervous Nelly investor jitters’! Im- portantly, the spread of shares in these types of products provides major risk management. This is vital when continuous deployment of capital is embarked on.
The strategy of dollar cost averaging is a useful concept when building a portfolio over some time. It certainly smooths over the peaks and troughs as well as assuage at least most concerns about declining markets. But as with any investment, you should always prepare for a reasonable time commitment.
