What a difference a year makes. This time last year investors were staring into the abyss of one of the nastiest bear markets in 50 years. As we count down the days to Christmas and the end of 2009 investors have enjoyed a resurgence on sharemarkets both here and around the world. Not surprisingly investor confidence has also returned and now it is common at seminars to hear investors saying that shares were at bargain basement discount prices back in March this year – and bemoaning the fact they were not buying. That’s the problem with market timing – you can only be truly confident that the time was right to invest with the benefit of hindsight and by then, for better or worse, the market has moved on. Regular readers will have heard the message about how hard it is to time markets many times over. And in the depths of the bear market also heard that at times of significant market volatility a long-term plan and the discipline to stick to it are basic techniques for taking some of the emotion and behavioral influences out of the investing equation. Dollar cost averaging – sometimes called systematic investing – is one way to implement a long-term savings and investment plan. Investing equal amounts of money over regular time periods – perhaps monthly or quarterly – is one way to reduce your risk of getting the timing wrong. But now we are living with more stable markets it is timely to see how an investor who had $25,000 to invest back in October 2007 would have fared during one of the worst market downturns this century if they had opted for a dollar cost averaging approach. Using the Vanguard Lifestrategy Growth fund which invests in a 70% growth assets/30% income assets not untypical of most super fund portfolios gives us a real-world example of how a diversified market portfolio performed for investors after fees. First consider the return for a lump sum investor – someone who invested the $25,000 on October 31, 2007. Two years on and with distributions reinvested and despite the market’s recovery this year the investment was still below water with a value of $20,384 on October 31, 2009. It hit a low point in February this year when the value was $16,596. Rewind to October 2007 and our second investor begins investing $1000 each month. Two years and 25 payments later and again with distributions reinvested the portfolio also was buffeted by the market storms but the at least is back into positive territory being worth $25,117. Under normal circumstances that is not going to get too many investors excited but given the extraordinary market conditions it is a reasonable result – most portfolios will not have recovered to their October 2007 values even with the market rebound. * The investor using dollar cost averaging certainly saw their investment go backwards as markets continued to fall until March when the market bottomed but by buying in to the market at regular intervals they bought units at lower and lower prices so that when the turnaround came in March this year they owned a greater number of units and the portfolio value rose accordingly. That is the secret to dollar cost averaging – the fact you are buying investment assets at lower prices if markets fall. Critics of the approach point out correctly that sharemarkets rise more often than they fall so that in growth markets you are actually buying assets at higher prices so the lump sum investor will be better off in long-run growth markets. That is true but it perhaps doesn’t lend enough weight to the behavioural aspect of investing – and in particular the risk side of the equation. There is also the practical consideration – not everyone has the financial capacity to make lump sum investments but can save smaller amounts regularly. If we are drawing lessons out of the past two years surely one is that risk is ever present and often unforeseen particularly as it may well lay dormant for a number of years building a false sense of confidence. Investing decisions are a series of trade-offs and dollar cost averaging is no different. You are trading off some potential gain for lower market timing risk. Investors who used a dollar cost averaging approach reaped the benefits of two forms of diversification – they spread their investments over a wide range of asset classes and diversified over time periods as well. * Assumptions - Dividends have been reinvested. No allowances have been made for tax.
13th-December-2009 | 