You’ve probably heard of dollar cost averaging as a way to grow your investment portfolio. It’s not the “be all to end all” for investing, but it can certainly help you make the most of investment markets and economic conditions over the long term.
Dollar cost averaging is quite simply investing a fixed amount at set intervals so an investor buys more units/shares when the price is low and less when it is high. Over time the costs average out and the investor usually ends up with more assets than if they were “timing the market” (which is a definite no-no).
Other benefits of dollar cost averaging include:
- It encourages discipline – once you have committed to the principle of regular investment, you are more likely to accumulate a useful asset than a pocketful of good intentions.
- It eliminates the need to decide when to invest – when it’s time to invest you do so regardless of what the market is doing.
Here’s an example
Your rich, yet eccentric uncle owns a tropical island. You and your ‘special someone’ have the opportunity to spend time alone on his idyllic island. He has given you $5,000 to buy tins of baked beans to take with you to supplement the island’s coconuts and berries on the basis that you can stay on the island as long as the beans hold out. You’re leaving for the island in five months’ time and have the $5,000 in hand to buy the baked beans. Remember, this is a great adventure for you… the more cans you buy the longer you can stay on the island. When you run out of baked beans, you both must return to reality and back to work.
Your favourite brand of baked beans is currently selling for $5.00 per can. Today you can buy 1,000 cans and beat any imminent price rises. Or you could wait until a sale and buy more cans at the cheaper price—but what if there is no sale between now and your five-month deadline? Simple, you will have to pay a higher price for your baked beans, which means fewer cans and less time in your island paradise!
There is another alternative—dollar cost averaging. On the first day of each month before your departure, you buy $1,000 worth of cans of baked beans regardless of the price. Will you end up with more baked beans? That depends on prices over the next five months. If prices only go up, you’ll have less baked beans than if you had bought it all at the start. However if prices fluctuate, there’s a good chance you’ll be better off with dollar cost averaging. The figures below show the outcome:
|Price of Baked beans||Buy at Start $5,000 buys||Buy at End
|Dollar Cost averaging
|Month 1 $5.00||1,000 cans||–||200 cans|
|Month 2 $4.00||–||–||250 cans|
|Month 3 $5.20||–||–||192 cans|
|Month 4 $4.50||–||–||222 cans|
|Month 5 $5.40||–||926 cans||185 cans|
|1,000 cans||926 cans||1,049 cans|
The “magic” of dollar cost averaging is that you can end up with an average buying price that is lower than the average price over the time period. During the five-month period, the baked beans averaged $4.82 per can; however you paid an average price of $4.77 per can. By using dollar cost averaging in this example you bought more cans of baked beans when the price was low, fewer when the price was high, but ended up with more for your money.
Convert the baked beans to dollars and you might be able to buy your own tropical island one day!