Home MMBIZ News The Magic of Dollar Cost Averaging

The Magic of Dollar Cost Averaging

Despite the uncertainties in the current global economic environment, with low interest rates and historical stock market valuations pointing to dangerous times ahead for both stock and bond investors alike, there is still a strategy that can help get you to retirement in great shape.

It takes a bit of discipline to follow but is mathematically as close to a sure thing as exists in the world of investments. Would you believe that you could start investing today and still make positive gains even in an environment where the market is lower in fifteen years than it is today?

I can prove it mathematically and will give a very basic example in a minute, but first let me explain how and why the strategy works. Dollar cost averaging basically involves investing a certain amount of money consistently over a long period of time in regular intervals. For example you could invest a thousand bucks every month into the markets over fifteen years, and at the end your total cost basis will be the average monthly price over those fifteen years.

As long as the ending market levels are higher than the average over the time period, you come out ahead. Over the last one hundred years, you could not pick a 15 year time frame where this strategy would not have worked.

It works even better if you average out as well, say over another fifteen years. This makes a lot of sense, since if you start saving at age 40 and retire at 55, you do not need your entire nest egg liquidated right away. You could start selling a little bit every month and get the average price over the coming decade or so. Since there is a long term uptrend in the markets, even the shakiest periods would not have been able to cause this strategy to fail. The idea here is to index, so you are diversified and get the market return.

To keep the numbers simple to illustrate the idea, imagine you save $1,000/month for five years and the S&P 500, or FTSE, DAX, or MSCI World Index, whichever you fancy, starts at $1,000 and you buy one unit per month with your investments for the first year to end up with 10 units. Let’s say the markets then drop suddenly to $500 and you spend the next three years buying units at this level, which now gives you 20 units/year because the market is essentially “on sale”.

At the end of the fourth year you would have 70 units, and then let’s imagine that the market rises to $750 and spends the final year at this level and ends there. This year you would have purchased 15 units to bring your grand total to 85 units.

Keep in mind you saved $12,000/year to total $60,000 invested at an average price of $705.88. You would have a profit of almost $45 per unit or $3,750 total. This is a 6.25 percent gain over a period where the markets ended down 25 percent from where they started.

Obviously the big gain in the final year exaggerates the point, but I hope this clearly demonstrates how you can make money even in a period where the ending level is lower than the starting point. When markets exhibit the kind of behaviour they always have over a long period of time such as fifteen years, this strategy will do amazing things for your retirement account, but it requires you to be disciplined and keep contributing despite what the account is worth at any given point in time. There will always be periods where the current value is less than the contributions total and this causes many to make the foolish mistake of abandoning the strategy at the worst possible time.

The great thing about this strategy is that there is never a bad time to start. Even if markets crash in early days, you simply end up buying more units at the lower prices. Don’t let the fear of a coming crisis keep you from starting to save towards retirement and/or your children’s university fees. The sooner you start the greater the long term effect of compounding will have on your overall wealth.

David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at david.m@faramond.com. Faramond UK is regulated by the FCA and provides advice on pensions and taxation.

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