Q: I have $35,000 in a term deposit account, which will eventually go towards a home loan deposit. I expect it will be a several more years before I am ready to buy a home and I have been talking to my family and friends about moving the money into some shares or a share fund. One of them suggested I use dollar cost averaging to reduce my risk. What does that mean?
A: Dollar cost averaging is an investment strategy that involves investing equal amounts regularly over a period of time (such as $1000 a month for 12 months) in a particular stock or investment product. Averaging is usually used when an investor is moving from cash into a more volatile share portfolio or fund.
The key benefit of averaging is that the investor removes some of the timing risk from the investment decision. An investment of $35,000 in a share fund, made all at once, could suffer significant loss if there is a market correction after the money is invested. Investing the money over a year or two lessens that risk.
There are plenty of investor anecdotes about buying shares at the worst possible time – just before a market correction – which leads to “buyers regret”.
By staggering the investment over time, if the market does fall more shares (or units in a fund) will be purchased when prices are low.
The investor has to decide on three parameters: the fixed amount of money invested each time, the investment frequency (monthly or quarterly), and the time horizon over which all of the investments are made (for example, 12 months or two years).
This approach to investing has its critics, who argue that for certain types of securities (such as buying shares through an online broker) averaging will increase transaction costs, potentially negating much of the benefit from reducing risk.
Critics also point to studies which suggest that a strategy that involves buying a fixed dollar amount of shares on a fixed day each month or each quarter provides no return benefit above a completely random purchase strategies – buying different values of shares on random dates.
Another criticism is that a portfolio put together using averaging may be more complicated to track for accounting and tax purposes.
A final concern about averaging is that human nature being what it is, many investors may be strongly tempted to attempt to time the market by suspending future averaging investments when the market is falling and resume when the market is rising.