Reduce your risk using dollar cost averaging
They say 'time in the market is more important than timing the market.' What this means, and research has shown, is that your investment returns depend more on picking the right investments and giving them time to perform are more important than picking the right times to buy and sell.
The best way to overcome trying to pick the peaks and troughs is to use the investment strategy called dollar cost averaging. Don't worry about the terminology - it's jargon for 'investing regularly.'
What is dollar cost averaging?
Put simply, dollar cost averaging is where you continue to invest a regular amount at regular times regardless of the market value, and you don't try to pick the right time. Over time, this will average the cost of your investment.
Let's take a look at an example illustrating how this works.
Alex would like to start investing in a managed fund.
Alex invests $1,000 into an Australian equities managed fund where the unit price has been fluctuating. If she invests $1,000 immediately, she will purchase units at $8 per unit. This will provide her with 125 units. However, if she invests $200 a year over five years in a fluctuating market, she will receive 141.51 units (at an average price of $7.07 per unit) over the period. By regularly investing during market fluctuations, Alex has bought more units and the average cost of her units has dropped from $8.00 to $7.06.
|Period||Investment ($)||Unit price ($)||Units|
|Total||1,000||7.07 (Average $)||141.51|
Note: This example does not take into account any distributions paid during this period. This is a general illustration of possible strategies only and is not an estimate of the investment returns you will receive or the costs you will incur. You should seek advice from a professional financial planner on your own personal circumstances before making an investment decision.
How it helped
What this illustrates is how dollar cost averaging has improved Alex's position. She has managed to secure a lower average unit price ($7.07 instead of $8) and if she redeems her units now, she will make a strong return.
Dollar cost averaging helps you maintain a disciplined approach to investing: when prices decline and many pull out of a market, you will continue to invest the same amount and acquire more units. And when prices are high, and many rush in, you will be buying fewer units. It eliminates market emotion from investment decisions and reduces the impacts of market peaks and troughs.
The only decision Alex has now is deciding when she should redeem her units. She is secure in knowing she has already done better than half the market.