Oh go on, one more investment related step before we end the series on investing… Despite its very boring name, dollar cost averaging is a powerful investment strategy that actually makes market volatility work in your advantage.
This is achieved in two ways:
- When the market is up you buy less shares, thereby avoiding investing a lot of money when shares are overpriced and when a crash might be just around the corner;
- When the market is down, you benefit by buying more shares, thereby making the most of the shares being “on sale”.
Let’s look at how dollar cost averaging works.There are generally two ways to invest: investing a lump sum or investing a set monthly amount. As we know markets go up and downs all the time and although most markets go up over time, they still experience periods when prices drop.
Lump sum investing
Imagine you have a windfall of say $10,000 that you want to invest. If you invest it all in one go at a time when the market is climbing, this might be a very poor moment to invest this money. Wait a few months and the market might well experience a downturn:
- Say the average price of shares at the moment is $100 then (costs excluding) you’d get 100 shares for your $10,000.
- Imagine the prices drop to $80 on average in the next 6 months. If you had held off investing for 6 months, you would have been able to buy 125 shares, i.e. 25% more!
- Now let’s say that another 6 months later the price of shares is back up to $100 a share again. If you entered the market today, you would have gained nor lost anything in a year’s time. Had you entered the market when shares were only $80 a piece, your portfolio would be worth $12,500 in a year’s time.