Dollar cost averaging

In an earlier article, Accumulating assets, we discussed our award-winning, ingenious get rich quick plan – buy low, sell less-low. Well, much like Patrick J. Adams in the hit legal drama which made lawyers seem cool (admittedly only to other lawyers), I’m a fraud. Yes, obviously it would be ideal to buy any asset at a low price, and offload that asset at a higher price. But this logic becomes harmful when people start to time their entry into the market based on whether assets are under or overvalued.

There’s a famous quote in the super exciting world of finance that goes something like this – Time in the market beats timing the market. In other words, in the long run, you would be much better off being invested in the market for an extended period of time, than you would be if you tried to strategically time entry and exit points based on shifts in prices. People seem to think an asset is overvalued because it’s expensive. “What makes it expensive?” you might ask. “It costs more than it used to”, they’ll typically reply. Here’s why that’s silly. In 1986, shares in Microsoft cost 10 US cents. In 1990 they cost 1 US dollar. By 1996 they were trading at 10 US dollars, and today they fetch just shy of 140 US dollars per share.

Now in 1990, these shares were ten times more expensive than they were just 4 years earlier. That certainly seems expensive. Let’s say you were in the market for a repulsive pair of sandals and you’d walked into your local Birkenstock retailer to discover that a pair you’d been eyeing for the past 4 years to rock on some European escapade was ten times more expensive than what you’re used to seeing. But consider how silly you might’ve felt if you hadn’t purchased those shares/birks at ten times the price, when you discover 6 years later that they’re yet again, ten times more expensive, or today, 140 times more expensive.

My point is, this isn’t how valuation works. You can’t just use historical share prices to make judgement calls about the value of a company. And by the same token, it would be silly to look at record high prices for any company or even the market as a whole and use those observations to time your entry into your investment. Well, what’s the solution? I’m not going to teach you valuation. It’s imperfect, extremely difficult, and this just isn’t the right platform for it. I’m not advocating ignorance, if of course you are interested, Google is your friend. What I am proposing to teach you instead is a super simple concept called dollar cost averaging.

What is it?

If you have a long-term investment horizon in mind, and you dollar cost average your investments, it doesn’t matter how expensive those investments are. Let’s say Nick wants to make a sizeable investment in the market. Nick has lived a particularly frugal life for the past year and has a cool $25,000 sitting in the bank earning next to nothing in interest. Nick is an informed and socially responsible investor so he picks an ethically conscious ETF, sufficiently diversified for his risk profile and opts to buy in. Nick has two options. He can either buy $25,000 worth of units in the ETF today, or he can dollar cost average. In the latter scenario Nick purchases $25,000 worth of units in the same ETF but over the course of a few months.

Why would anyone do this?

If Nick was absolutely certain (he couldn’t be, this is a hypothetical) that units in the ETF would only rise in value over the short term, it would be silly to dollar cost average. He has the money now, and purchasing at regular intervals only means buying those same units at a higher price each time. But what if the market is creeping downwards? Let’s say in week 1, each unit in the ETF costs $50. What if the next week they cost $49, or $47 the following?

Say Nick had been extremely unlucky, and by the time he was finished with his $25,000, each unit in the ETF cost $40. Had Nick purchased his units at regular intervals, his average entry point might be $45 instead of $50, saving him 10% in losses. On the other hand of course, Nick would also stand to lose potential profits if the ETF had risen in value and he had opted to spread out his entry point. Whether the market goes up or down, Nick is dollar cost averaging the price of his investment. It doesn’t matter which direction the market shifts in. The point is, the uncertainty around prices means that in the long run, it makes more sense to spread out your entry point, and therefore your initial investment price.

Does this mean you can turn a blind eye to prices? Absolutely not. Ignorance will never be bliss. Very much unlike that pair of sandals, intelligence is sexy. Being knowledgeable about all the things will always be appealing. A savvy investor tracks market prices and the market conditions which drive changes in those prices. Say for example Nick dollar cost averaged his $25,000 and then some. Say he was so happy with the performance of his ETF he started setting aside fractions of his weekly salary to continue investing and over a period of 2 years, he had accumulated a $50,000 portfolio. Now if Nick has genuinely done his due diligence and he’s firmly of the view that a bear market (prices dipping 20% or more since recent highs) is coming, no one is advocating that he should keep his money tied up and suffer such losses. Shares and units are after all liquid assets (see Accumulating assets) and can very easily be purchased and sold.

You are already dollar cost averaging

Almost all my friends neglect their superannuation accounts because it’s out of sight, out of mind. But your superannuation accounts are already dollar cost averaging your investments for you. A fraction of your fortnightly remuneration is diverted to your superannuation where you purchase a number of units on a fortnightly basis. Unless the market is stubbornly stagnant, each time you buy units, you’re buying units at a different price and your overall entry price into the fund is being dollar cost averaged.

Warren Buffett once famously said, “our favourite holding period is forever.” At the end of the day, no matter how amazing an investor you are, you will never be 100% certain where prices are going. Therefore, you will likely hurt yourself if you keep entering and exiting the market at low and high points respectively. Statistically speaking, the best investments are long-term investments and dollar cost averaging can help give you some peace of mind about the cost of your initial investment.