There is no hiding that share markets around the world have had a poor year to the end of June 2008, and July has not provided any real comfort. History tells us that there will be an upswing in returns but unfortunately it does not provide us a guide to the exact date of that turn around. It could be tomorrow, in a month, the next quarter, a year or even multiple years time.
A number of investors may be now sitting in the position where they have accumulated cash and are pondering whether it is time to be buying into growth assets. This could be through accumulated savings, hesitancy to invest over the past 9 months or you may be the holder of managed funds and have recently received income distributions into your portfolio.
If you take the decision to buy into growth assets a wise option would be to undertake a dollar cost averaging approach. So what is dollar cost averaging and how might it protect you from downside risks?
The following is taken from Scott Francis' latest book - A Clear Direction - Your Guide to Being a Successful CEO of Your Life
Investing regularly over time is sometimes given the 'Flash Harry' name of dollar cost averaging. It is called this because if you keep adding investment amounts regularly you buy more of an investment if prices go down and less if prices go up - tending to average out your entry price over time.
In the first chapter of 'A Clear Direction - Your Personal Finance Guide' I indicated that I felt there was a bias towards the use of the phrase 'It's time in the market, not market timing that counts' within the financial services industry. I feel that this bias comes about because promoting the idea that provided you leave an investment in the market for three to five years you will make a reasonable return, means that there is never a bad time to invest. For commission based financial planners who earn their money through distributing financial products, and for fund managers who charge a fee based on the percentage value of assets that they are managing, the fact that it is always a great time to invest means it is always a great time to take clients' money - which is great for their own profits.
The reality is quite different. For example, if you had invested a sum of money in the stockmarket in July 1970, it would have taken until July 1985 for you to receive a positive return above the rate of inflation. Even without considering inflation it would have taken eight years to have the investment return to its purchase value again.
If you had invested $10,000 into Australian Shares in July 1970 by July 1985 that portfolio would be worth $27,454. This sounds impressive. However because of inflation by July 1985 $27,454 would only buy you the same amount as $10,000 would in July 1970 - all in all a disappointing investment return.
If, rather than invest the $10,000 all at once, you had invested $1,000 a year for each of the first ten years by July 1985 your investment portfolio would have been worth $30,245, an investment return nearly $3,000 stronger.
This is a demonstration that in times of volatile markets, such as during the early 1970's, the strategy of regularly investing smaller amounts of money can be an effective one - more effective that just assuming any time is a great time to invest and blindly investing money. Of course there are periods of strong investment returns where it would be better to simply invest the $10,000 up front. Just as the strategy of investing small amounts regularly helps smooth volatility that will protect against losing capital in less attractive markets, it will reduce your investment returns in more attractive investment markets.
It is also practical to assume that most people will set their investment goals and invest periodically. For example, they may decide to save and invest $5,000 a year, so the practicality is that they will be investing regularly over time, which we have seen is a prudent way to enter investment markets, allowing them to use any downturn in investment prices as a buying opportunity, and smoothing market volatility.
Let's assume that a person decides to invest $1,000 at three different times into an Australian share, called share X. At the first point of investment the price of the share was $1, so she purchased 1,000 shares. At the second point of time the price of share X was 50 cents, so she bought 2,000 shares. At the third point of time the price of share X was $2, so she bought 500 shares. The share price then fell back down to $1. At this point in time she had 3,500 shares, worth $3,500. So, even though the price of these shares is the same as when she first bought them, dollar cost averaging means that her $3,000 investment now has a value of $3,500.
To look at a realistic example of regular investing over a period of time I put together a model based on the time between July 1970 and July 2005, a 35 year period. I assumed that a person worked and earned the average weekly wage for each of these years, as per the Australian Bureau of Statistics (ABS) figures for each year. Each year they contributed 5% of their income. This means that in 1970 they contributed around $185 through to 2005 where they invested nearly $2,000. I have assumed that they invested all their money in Australian Shares, and reinvested all dividends. I used the actual returns from the sharemarket over this period. If they did this, by July 2005 they would have an investment portfolio valued at $288,000. The effect of compound interest is that they would have only contributed $36,410 over the 35 years. The remaining value of the portfolio is made up of investment returns. While this example has not taken into account tax, the final balance is significant.
How to apply this?
Since early 2007, we have been advising new clients, and existing clients with new money to invest, to gradually ease into growth markets through dollar cost averaging.
This strategy, combining the effect of compounding interest with regular investments to smooth some market volatility, requires the discipline to start investing as soon as possible and to regularly allocate funds to your investment portfolio.
It is a two step process which involves:
1. Identifying how much you can put towards long term investments on a regular basis and;
2.Deciding how you are going to actually invest, using either index funds, actively managed funds or choosing investments directly (or a combination of all three). If you choose a managed investment then you should establish a regular investment facility to keep building your investment over time. If you choose to invest directly yourself, you should open a high interest investment bank account where you can regularly build your savings until you are ready to choose the next investment.
For more information on our approach to building portfolios please take a look at our Building Portfolios page on our website.