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The ups and downs of dollar-cost averaging

Nicki Bourlioufas  |  22 Jan 2018Text size  Decrease  Increase  |  
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Following a simple practice known as dollar-cost averaging to buy shares, investors can devote money to the share market without trying to time highs and lows.

However, the strategy doesn’t always make financial sense, and the sooner you invest, likely the better. If you believe stock markets will rise over time, then the best time to invest is now, before trying to time any low in prices, according to some experts.

In contrast, dollar-cost averaging involves investing a set amount of money in stocks at regular intervals. By investing this way, you are not attempting to pick the lows or highs of the market. Rather, you buy shares over a regular period of time rather than invest a lump sum at a particular point in time.

For example, a total of $200,000 could be divided into 10 equal amounts of $20,000 to invest over 10 years irrespective of how markets perform. This contrasts with investing a lump-sum of $200,000 from the outset.

So, which investing strategy wins out? Buy now and invest a lump sum, or average out your investments over time?

Robin Bowerman, principal, market strategy and communications at Vanguard Australia, says there are pros and cons to using dollar-cost averaging.

“It certainly can be a valid technique but if you accept that markets generally go up over the long-term, the earlier you invest, the better off you will likely be over the long-term by taking full advantage of any rise in share prices.

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“A Vanguard research paper found that, given certain assumptions, investing a big lump sum all at once had a better chance of producing higher long-term returns than drip-feeding the money into the market using dollar-cost averaging. This finding was based on historic long-term returns from share and bonds in Australia, US and UK. As the paper emphasises, investment of a lump sum gains exposure to the markets as soon as possible,” he says.

However, where dollar-cost averaging does make sense is that it encourages investors to buy shares in a non-emotional way rather than trying to time markets.

“For most investors without a huge windfall to invest, a critical role of dollar-cost averaging is to help keep us focused on the long-term in a disciplined, non-emotional way. It is one of investment's emotional circuit breakers,” Bowerman says.

Financial adviser Bruce Brammall agrees and says dollar-cost averaging is a form of disciplined investment that allows people to build up their wealth, without taking on the risk of investing in the share market at its peak.

“Dollar-cost averaging turns investing into a regular savings plan, that is, you invest in the money on a regular basis, say monthly, irrespective of whether share prices are rising or falling.”

If people receive a lump sum, whether an inheritance, employment payout or someone rolling over a large sum into a self-managed superannuation fund, dollar cost averaging spreads out investment risk.

“The reason for dollar-cost averaging or investing over a period of time is to spread the risk out that you aren’t investing at the market peak. So, if you do have a lump sum to invest, and your stock broker or adviser advises you to invest, it’s a riskier approach and it relies on the belief that share prices will keep on rising. Dollar-cost averaging diminishes the risk of potentially investing just as the market is about to crash,” says Brammall.

A calculator published by AMP can help investors compare the outcomes of dollar cost averaging in three scenarios. First, where share prices fall over a period of time but recover to their original position. Second, in a market where prices fluctuate and third, in a market where prices rise. The calculator shows that in the first two scenarios, dollar cost averaging leads to a better investment outcome as assets are purchased at an overall lower average price.

According to MLC Financial Planning’s Understanding Investment Concepts document, dollar-cost averaging makes sense when markets are falling.

“By regularly investing in an investment market, you are not relying on timing strategies aimed at picking when a market has bottomed or peaked. Dollar cost averaging imposes a helpful investment discipline by completely ignoring timing issue.

The strategy may be “beneficial when markets may fall. This is because only a fraction of the total amount to be invested is exposed to declines in the market. Also, when the market price falls, your regular investment amount will purchase more investment shares or units, and providing a sound savings regime and ideal investment strategy for people with a regular income but without large sums to invest.”

However, “when market prices are trending upwards, a portfolio purchased up front will do better than the portfolio purchased using dollar cost averaging. This is because the full gain on the price rise is captured by the full amount of money invested up front,” MLC says.

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is a Morningstar contributor.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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