Is Dollar Cost Averaging the way to invest in this volatile market?
The Australian stockmarket hit an 18 month low of 5,001 points on 24 Aug 2015. This was 16.1% off the highs reached in April 2015. In the next six trading days, it bounced between 5,263 and 5,096 points. The market seems to be trading in a range that is about 10% below the levels during March-April 2015.
Some investors are thinking that this is a good opportunity to buy. After all, Warren Buffett says "be fearful when others are greedy and greedy when others are fearful". Other renown investors back this idea of buying in a market downturn.
But buying when others are selling is hard to do mentally. Being a contrarian takes guts and discipline, especially when you are talking about your hard earned money.
You can improve your returns if you are able to predict the direction of the market. The only problem is that we don't believe it is possible to time the market.
So, we don't know which direction the market is going. But we want to get into the market because it feels like it is near good value now. What can we do?
Well, to reduce the risk of buying into the market now to only see the market drop further, you can consider using Dollar Cost Averaging.
What is Dollar Cost Averaging (DCA)?
DCA is a technique of investing your money. You invest a fixed amount of money in set time intervals regardless of the price. The idea is that you end up buying more of the shares when prices are low, and less when prices are high.
An example of how Dollar Cost Averaging strategy works:
- Mary wants to invest $12,000 in Commonwealth Bank and decides to use a DCA approach;
- She decides to invest that $12,000 over a 6 month period. She will invest $2,000 per month for 6 months;
- Commonwealth Bank's share price over the 6 month period:
- Month 1: $78.00 - buying 26 shares
- Month 2: $76.00 - buying 26 shares
- Month 3: $74.00 - buying 27 shares
- Month 4: $73.00 - buying 27 shares
- Month 5: $71.00 - buying 28 shares
- Month 6: $74.00 - buying 27 shares
- After the DCA investment program, Mary has 162 shares in Commonwealth Bank. The average price she paid for the shares is $74.27;
- If Mary simply purchased $12,000 when the price was $78.00, she would only have 154 shares. Her average price would be $78.00 per share, some 5% more than price she paid under the DCA method;
- In this example, the market is in a downturn, when Commonwealth Bank shares dropped over the 6 months. In this scenario, Mary would own more shares, having paid less for each share when using the DCA method. This will position her to make more profit when share price rises in the future.
What about some real world examples?
If you are thinking about getting into the sharemarket now, would DCA help you? A good way to think about this is to see what would have happened if you implemented the DCA method in the past.
Let's have a look at three scenarios in the last 10 years, when the Aussie stockmarket hit an 18 month low:
- Down market: At the start of the GFC, 3 July 2008. The ASX 200 Index hit 4,998 points
- Up market: At the end of the GFC, the bottom of the market, the ASX 200 Index hit 3,332 points on 24 Feb 2009
- Steady market: 5 Aug 2011 when the ASX 200 Index hit 4,105
In each scenario, Mary has $30,000 to invest. She will either invest it as a lump sum, or use the DCA method to invest $5,000 per month over 6 months.
In all scenarios, Mary will invest her money in the ASX 200 Index, reinvesting her dividends, and holding on to the investment until 25 Aug 2015.
The Down Market Case
ary's lump sum investment of $30,000 on 3 July 2008 would grow to $42,563 by 25 Aug 2015.
If Mary invested with the DCA method, her investment would be worth $49,102. This value accounts for her earning $438 of interest income when she had cash sitting there waiting to be invested. It also accounts for the extra brokerage she has to incur, making 6 trades instead of one with the lump sum method.
During the 6 months that Mary implemented her DCA, the ASX 200 fell by another 25.5%. This made her entry price lower using the DCA method. In the Down Market Case, Mary is making average annual return of 7.1% with the DCA method, compared to 5.0% return with the lump sum method.
The Up Market Case
Mary's lump sum investment of $30,000 on 24 Feb 2009 would grow to $61,680 by 25 Aug 2015. Under the DCA method, her investment would be worth $54,130.
During the 6 months after 24 Feb 2009, the market went up by 27.4%. This made Mary's average entry price much higher under the DCA method.
In the Up Market Case, Mary made 11.7% average annual return with lump sum method, compared to 9.5% return with the DCA method.
The Steady Market Case
Mary's lump sum investment of $30,000 on 5 August 2011 would grow to $45,348 by 25 Aug 2015. Under the DCA method, her investment would be worth $44,427.
During the 6 months after 24 Feb 2009, the market was relatively flat, increasing by 3.8%. This made Mary's average entry price slightly higher under the DCA method.
In the Steady Market Case, Mary made 10.7% average annual return with lump sum method, compared to 10.2% return with the DCA method.
What does it all mean?
Like most things in finance, there is no magic formula. Dollar Cost Averaging benefits are also it's problems - it is a double-edged sword. It all depends on which direction the market takes.
- In an up market, DCA will lead to buying when prices are rising. This will reduce your returns
- In a down market, DCA will lead to buying when prices are falling. This will increase your returns
DCA does have one clear negative in all market conditions. You will incur more brokerage fees. This will definitely be negative to your returns. But how much this affects your return will depend on the size of your investments.
In a world where it is super hard to pick market movements, maybe it is worth considering your risk appetite in determining whether to use DCA or not.
If you don't like risk, prefer to protect your money rather than make more money - DCA makes sense. With DCA method, your returns will be more protected when the market heads south, but growth will be limited when the market goes up.
The reverse is true for risk takers. DCA is probably not for you.