Dollar cost averaging is an approach to investing that does not rely on emotions or gut feelings.
It works like this: You put a fixed amount into a fund every month, regardless of market behaviour and the price of units.
If the price of the fund goes down, you buy more units; if it goes up, you buy fewer units. There is a greater possibility of buying more units during periods of market fluctuations, as fund prices fall.
What this means is that your average unit cost will likely be less than if you made an equivalent lump sum investment at its unit cost.
The statistical effect becomes more obvious over time, especially in volatile markets, as the illustration below shows.
When emotion rules
We’re rational investors who make sound investment decisions based on market fundamentals. Or so we’d like to think.
But more often than not, we’re led by our emotions when it comes to investing, much like ‘Mr Market’, an imaginary, albeit true-to-life character created by investment guru Benjamin Franklin in his seminal book, “The Intelligent Investor”, in 1949.
Much like any investor, but perhaps with a degree of exaggeration, ‘Mr Market’ is driven by emotions – optimism, euphoria, panic, anxiety – when it comes to making investment decisions (see chart 1).
The thrill and excitement of seeing the value of your investments go up in a rising market could as quickly give way to a period of anxiety and even desperation, when asset prices fall. Investors are particularly vulnerable to poor judgment (ie, selling off a security at a loss) in down markets. What investors tend to overlook is that the best bargains can in fact be found during periods of indiscriminate market sell-offs, provided they keep a cool head and do their homework.
Then there’s market timing. Markets invariably move in cycles and Asia has seen its fair share of ups and downs over the past two decades (see chart 2). The Asian financial crisis, dot-com bubble, SARS, and the global financial crisis are stark reminders of how vulnerable markets are to unexpected events and sentiment swings.
We all flatter ourselves that we can spot the right moment to enter or exit the market. In practice, luck, mostly bad, plays as much a part as skill. Indeed, while the age-old advice to buy low and sell high is simple and obvious, our very unsystematic behaviour leads many of us to do the opposite.
It’s important therefore to invest regularly and stay invested.