Dollar-Cost Averaging

Now that you have an idea about the risks and different investment option let’s look at an investment strategy.

Dollar-cost averaging is a name given to an investment technique where you drip feed into an investment. This reduces the timing risk associated with volatile investments such as shares and funds. Many people avoid shares because the markets move up and down, and they don’t want to risk buying in that the wrong time. It is a  real fear. Let’s look at how dollar-cost averaging can minimize this.

You set up an automatic regular investment plan of $100 per month. In July, you buy some shares at the cost of $1.00 each. Now you have 100 shares. In August, you again invest $100. The price of a share has dropped to $0.95. Therefore you buy 105 shares. In September, the price of shares had fallen further to $0.85, so you buy 118 shares. However, in November the shares have gone up to $1.05, you purchase 95 shares.

You end up with a total of 418 shares for a price of $0.96 each.  If you had bought only in July, or November, you would have had fewer shares at a higher price, if you had bought in August you would have more shares. But because you used dollar-cost averaging, you purchased your shares at an average price and removed any timing risk involved.

This works because when the market falls, you can buy more shares, and when the market rises, you buy less. In the end, it all averages out. You can use dollar-cost averaging in two ways, through regular savings and when you want to make a lump sum investment.


Regular Savings

If you save and regularly invest, for example, paying yourself first at every paycheck, you can use dollar-cost averaging. Drip feeding your savings into the stock market or investment fund will take advantage of dollar-cost averaging and smooth out any volatility. If you are in KiwiSaver, you are automatically using dollar-cost averaging, even if you didn’t know about it.


Lump-sum Investment

If you have a lump sum of money to invest, you could set up a series of automatic payment rather than try time the markets.  This will minimize the potential risk of a market turn wiping a substantial portion of your investment.

These two cases will protect the value of your investment from volatile markets.

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