If you are following along with our Investment Basics series, we’ve already discussed the three main asset classes – Money Market, Fixed Income, and Equities. Now I know some of you may be thinking, “We are in the midst of the COVID-19 crisis, and the thought of investing money in the stock market right now is not for the faint of heart!” So, what should you do if you have cash sitting on the sidelines? In today’s turbulent markets, it is entirely possible that you could invest the lump sum and the very next day see your investment down a substantial amount. Of course, the reverse is also true. Nobody holds a crystal ball. In this post, we’re going to discuss a strategy called dollar cost averaging (DCA), which can allow you to dip your foot in the equities pool a little bit more on a regular basis.
I want to stress that this post is not intended to be individual investment advice, but rather a strategy that you may want to consider for yourself or discuss with your investment advisor.
Consider the following scenario: Sarah inherited $100,000 that she would like to invest in equities. While she is investing for the long-term, the market was down a whole bunch yesterday and she worries, “What if I invest my money and the market has another bad day or week or months?” Sarah is a long-term oriented investor, but nobody likes losing money, even temporarily, if they can avoid it. Rather than make a lump sum investment her advisor suggests that she implement a dollar cost averaging strategy. Under this strategy she will invest a fixed amount on a monthly basis into a well-diversified mutual fund. If you want a refresher on how mutual funds work, be sure to check the SeeWhy Learning YouTube channel for the video titled “Managed Products”.
At SeeWhy Learning we often exaggerate to make a point easier to understand, and I’m certainly going to do that here. Instead of focusing on the actual numbers I am using, just focus on the concept. At the beginning of Month 1, when Sarah made her first contribution, the net asset value per unit (NAVPU) was $20. NAVPU is just a fancy term for unit price. Sarah invested $10,000. By the beginning of Month 2, the NAVPU fell the $10 – half of what it was the month before (this is where I’m exaggerating a little bit to drive home the point). Sarah sure is glad she didn’t invest all of her money in Month 1! She sticks to the plan and invests another $10,000. By the beginning of Month 3, the NAVPU had rebounded a little bit and sits at $14. Sarah invests another $10,000.
At first glance, things don’t look too good for Sarah. One thing is for sure – her first contribution is worth much less than what she invested. Let’s see how the overall portfolio has performed so far. In Month 1, when the NAVPU was $20, Sarah invested $10,000 and would have acquired 500 units calculated as follows:
= $10,000 Investment / $20 NAVPU
= 500 units
In Month 2, the NAVPU had fallen by half. Sarah was able to pick up twice as many units, calculated as follows:
= $10,000 Investment / $10 NAVPU
= 1,000 units
In Month 3, the NAVPU had rebounded a little bit to $14 and Sarah acquired a further 714.29 units,
= $10,000 Investment / $14 NAVPU
= 714.29 units
So, what is the portfolio worth today? In total, she has 2,214.29 units. If we multiply that amount by the current NAVPU of $14, her portfolio would be worth about $31,000, which is a $1,000 more than she invested.
I want to stress that dollar cost averaging does not insulate you from losses. If the market continued to fall, Sarah would certainly lose money, but she would have done better than trying to time the market and getting it wrong. This is not to suggest that investors can’t make money by timing the market, but it’s really hard. When it comes to investing, the risk-reward relationship is always in play. If you do time your investment and invest at precisely the right time, you’ll be glad you did. However, if you do so at precisely the wrong time, not so much. Nobody has a crystal ball though, so dollar cost averaging is worth considering.