Whether it’s all new to you, or have some previous experience, investing your hard-earned dollars can be daunting. How can you be sure you’re entering the market at the right time?
One of the methods financial advisers use is Dollar Cost Averaging, which helps to reduce timing risk.
How does it work?
Instead of investing all your funds in one go, Dollar Cost Averaging invests smaller fixed amounts over an extended period of time until the full amount is invested.
The price of the investment may fluctuate over that time period, but the same amount is invested regardless of the unit price at any given time. Essentially, this means that you end up buying more of the asset when the price is lower, and less when the price is higher. This helps take the risk out of trying to pick the ‘best’ time to buy.
Lets say an investor has $6,000 they want to invest in XYZ Ltd. The investor can buy $6,000 of XYZ stock today, but the share price has been rather up and down lately and they don’t want to risk the share price dropping too far after having invested their entire $6,000. In this instance the investor decides to dollar cost average at a rate of $1,000/month for 6 months.
|Month||Investment||Share Price $||Units Purchased|
|Total invested = $6000||Average share price = $7.0812||Total units purchased = 1255|
If they had invested the full $6,000 in the first month the investor would have ended up with 750 units at $8 each. Because the funds were invested over 6 months, they were able to take advantage of fluctuating share prices to end up with a total of 1255 units at an average price of $7.0812 each.
While the share price did drop to as low as $2 at one point, by the end of the 6 months their 1255 shares were worth $6.66 each, making their portfolio worth $8,358.30. Had they instead invested the full $6000 into 750 shares in month 1, the shares that they bought at $8 each would only be worth $6.66 each after 6 months. Their portfolio would be worth $4995, a $1005 loss at the 6-month mark.
As you can see, DCA helps to spread the risk across a time period of your choice. However, it’s important to remember that DCA is not a risk-free strategy and under some circumstances investor may have actually been better off investing the entire lump sum in one go.
Want to know more? Contact us to have a chat with one of our financial planners.
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