Article by David Press (B.Comm)
The power of fear and greed in the market has been as evident as ever through the last five or six years in which we have seen a sustained bull run, largely due to the growth of China and demand for commodities in which almost any stock proved a winner, followed by the rapid collapse in which virtually no stock was spared the wrath of a worldwide credit crunch and failed financial markets. Throughout the bull run the idea of long term investment was almost forgotten by many with short term positions in running stocks creating huge profits, but the rapid collapse has reminded us of some important home truths about volatility and the need for a long term view to investing.
One strategy widely recommended in order to smooth out volatility in the long term is ‘Dollar Cost Averaging’. By making regular purchases/contributions to an investment, the investor removes the market timing risk of said investment and smoothes volatility by buying regularly throughout the up and down cycles of an investment.
As a simplified example, Investor A uses the dollar cost average strategy and invests $1000 in ‘XYZ’ each month starting in January and does so for a total of 12 months. Investor B purchases 2400 shares in company ‘XYZ’ in January for $5.00 a share. Investor B has invested $12 000 as a lump sum in one purchase.
| | Investor A With Dollar Cost Averaging | Investor B No Dollar Cost Averaging |
| | Price ($) | # of Shares | Price ($) | # of Shares |
| January | 5.00 | 200 | 5.00 | 2 400 |
| February | 4.50 | 222 | | |
| March | 4.25 | 235 | | |
| April | 4.50 | 222 | | |
| May | 5.25 | 190 | | |
| June | 4.50 | 222 | | |
| July | 5.25 | 190 | | |
| August | 5.50 | 182 | | |
| September | 4.25 | 235 | | |
| October | 4.75 | 211 | | |
| November | 4.25 | 235 | | |
| December | 5.00 | 200 | | |
| | | |
| Ave Buy Price | $4.75 | $5.00 |
| Total # of Shares | 2 546 | 2 400 |
| | | |
| Portfolio Value | $12 729.23 | $12 000 |
The end result after twelve months, due to volatility in XYZ’s share price and Investor A’s dollar cost average strategy, is that Investor A has purchased 2 546 shares in XYZ for an average price of $4.75, whilst Investor B has purchased 2 400 shares for an average price of $5.00. The difference in portfolio value after twelve months is $729.23 in favour of Investor A. Obviously brokerage costs need to be taken into account for the additional purchases, but even so, at a price of around $30 a trade using an online discount broker, the additional costs are around $330, resulting in a net result of around $400 in favour of the dollar cost average strategy.
The above example is somewhat simplified and only shows the results over twelve months which in relative terms is on the short side, however the example does show the effect of taking a long term view to investing and utilizing a dollar cost average strategy. It is because of market volatility that we are currently experiencing that it is often recommended that investors entering the stock market should do so with a view to investing in the long term with a minimum time frame of 5-7 years to take into account any negative return periods and minimize timing entry risk.
Each individual investor’s situation is different and each has differing needs and financial objectives, as such it is strongly recommended that you seek advice from a trained professional. This article provides general information only and should not be considered advice.