Dollar cost averaging - the benefits of a market downturn

3 mins

Against a backdrop of market volatility and low interest rates it’s good to remember that there are strategies that could benefit investors when asset prices drop.

Dollar cost averaging is a strategy that can benefit investors as markets go down.  How it works is that by regularly investing a set amount of money, when prices are high your money can only afford you a certain number of assets, but as the asset price drops you are able to afford more of them. When the market recovers, you will benefit from having more of the assets you bought when the prices were down. 

This strategy is used for superannuation members who make regular contributions to their account.

How does dollar cost averaging work?

By regularly investing a small amount each period, as you are likely to do if your employer makes super guarantee contributions or if you make regular further super contributions under salary sacrifice arrangements, you buy more of an asset when prices are low, and buy less when prices are high. This allows you to average out your asset buying costs over time, and reduces the risk of buying too much of an asset at a time where prices are particularly high, while capitalising on the opportunity during a market downturn to buy more of an asset, for which you could be better off later down the track if asset prices rise again.

In contrast, if you were to make a one-off lump sum investment, you face risk in the attempt to time the market. That is, if you invest a lump-sum at a certain price, there is a risk that your entire investment will suffer a market-sell off, as was the case with the GFC, rather than just a small contribution. While you might be better off investing a lump sum if you were to time the market well, the reality is that it is extremely difficult to do so. Further, by making a lump sum contribution, you may experience a greater dispersion of returns.

Here’s an example

Let us take a look at the month-end share price of hypothetical Company A and invest $10,000 under three scenarios, as shown in the tables below.

Scenario 1: $10,000 is invested as a lump sum

Month

Share price

Investing under the best case

Units purchased

Investing under the worst case

Units purchase

January

$32

 

 

 

 

February

$31

 

 

 

 

March

$29

$10,000

345

 

 

April

$31

 

 

 

 

May

$33

 

 

$10,000

303

June

$30

 

 

 

 

Value of units at period end (June 2019)

 

$10,345

 

$9,091

 

Under the best possible case, the investor would have purchased 345 units at the lowest price during this period, and profited from a $345 capital gain by June. Under the worst case, the investor would have purchased 303 units at the peak, and suffered a capital loss of $909 by June. The variability in returns is equal to a value of $1,254.

Scenario 2: Two $5,000 investments are made

Month

Share price

Investing under the best case

Units purchased

Investing under the worst case

Units purchase

January

$32

 

 

$5,000

156

February

$31

 

 

 

 

March

$29

$5,000

172

 

 

April

$31

 

 

 

 

May

$33

 

 

$5,000

152

June

$30

$5,000

167

 

 

Value of units at period end (June 2019)

 

$10,172

 

$9,233

 

Under the best possible case, the investor would have purchased a total of 339 units at two of the lowest prices during this period, and profited from a $172 capital gain by June. Under the worst case, the investor would have purchased a total of 308 units at the two of the highest prices during the period, and suffered a capital loss of $767 by June. The variability in returns is equal to a value of $939.

Scenario 3: Five $2000 investments are made

Month

Share price

Investing under the best case

Units purchased

Investing under the worst case

Units purchase

January

$32

$2,000

63

$2,000

63

February

$31

$2,000

65

$2,000

65

March

$29

$2,000

69

 

 

April

$31

$2,000

65

$2,000

65

May

$33

 

 

$2,000

61

June

$30

$2,000

67

$2,000

67

Value of units at period end (June 2019)

 

$9,814.93

 

$9,564.15

 

Under the best possible case, the investor would have purchased a total of 327 units by spreading their purchases during this period, and made a capital loss of $185.07 by June. Under the worst case, the investor would have purchased a total of 319 units during the period, and suffered a capital loss of $435.85 by June. The variability in returns is equal to a value of $250.78.

By investing as a single lump sum, performance variability rises as your returns depend on your ability to time the market. The above best and worst case investment decisions can only be known in hindsight, and it should be noted that past performance is not indicative of future performance. By making more regular, smaller investments, you can reduce the variability in returns due to dollar cost averaging, and this increases your likelihood of achieving a return similar to ‘market return’ over longer time periods. Note also, that as volatility increases, divergence in returns increases. This suggests that in times of great volatility, regular investments such as your super contributions can be particularly important in helping to reduce risk over the longer term.

While a dollar cost averaging investment plan may not always lead to better returns than a lump-sum investment, it can help to reduce risk by removing the need to time the market. This is particularly important if you are risk averse and are looking to reduce the likelihood of changing your investment decisions under the stress of the markets.

Creating a regular investment plan

While your employer may already be making regular contributions to your super which benefits from dollar cost averaging, you could also consider contributing more to your super through salary sacrifice or personal contributions. You can also consider creating a regular investment plan outside of your super. This strategy can help to provide a disciplined approach to investing, while helping to smooth out market fluctuations. 

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This article was prepared by BT, a part of Westpac Banking Corporation ABN 33 007 457 141, AFSL and Australian Credit Licence 233714. This information is current as at 19 August 2019.  This article provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. The information provided is general in nature and does not constitute financial product advice.  Before acting on it, you should seek independent advice about its appropriateness to your objectives, financial situation and needs. This information may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material.