Sharemarket basics: dollar cost averaging

Whether the sharemarket is rising or falling, you can do well if you pick its highs and lows. Trouble is, of course, it's not a simple thing to pick those peaks and troughs. Correctly timing your entry into and out of the markets is the Holy Grail of investment and virtually impossible to do repeatedly without an operative crystal ball.

Financial planners constantly warn about the hazards of trying to time your movements into and out of the markets, pointing out that unless luck is on your side you're likely to be out of the markets when you should be in them, and vice versa. It's better, they say, to be in the markets all the time, and ride out the inevitable ups and downs.

The logic underpinning this advice is that over the long term, mainstream markets rise in value. So, invest in them and stay invested, and only sell when you need the money for some worthwhile purpose.

The maxim is: "It's time in the market, not timing the market [that works]."

It's a fact that the Australian sharemarket, for instance, since its inception has never failed — up until November last year, that is — to rise after a downturn to a higher level than its previous peak. Is this trend now likely to have permanently ended? History, and the odds, would strongly suggest not.

Furthermore, according to ipac securities, very long-term returns from Australian (commercial) property have been in the range of 3% to 5% above inflation, while Australian shares have historically returned 5% to 8% above inflation — with every likelihood of this long-term pattern continuing.

Human nature being what it is though, lots of us do try to time the market — after all, like having a good day at the races, if you get it right you’ll make a killing. But our track record in this department, generally, is not encouraging. Propelled often by a dicey combination of factors including fear, greed, ignorance, and AAA ratings being given to ZZZ-class investments, we often buy into investments when they're overheated, and sell when they've gone cold — buying high and selling low — which is a surefire way of losing money.

Enter dollar cost averaging, the antidote to market timing. With this very straightforward concept, you simply decide to invest a set amount on a set schedule into a set investment, and stick to it, e.g. $1500 on the first day of every third month into an Australian share fund.

Market timing thus becomes irrelevant. It doesn't matter if the market is up or down, you just keep on investing — on the premise, which history supports — that being invested long term is better for you than not being invested.

A mathematical aspect of dollar cost averaging is that when markets are down, your set, regular investment will buy you more shares/units, and when markets are up, it will buy you less. Long term, this has the effect of averaging out the price you pay, meaning that while you may not get your shares or units at a bargain price, you won’t pay too much either.

What's also significant is that through dollar cost averaging you will in fact build an investment portfolio, as opposed to not building one. Furthermore, you will have built this portfolio without having had to worry once about when to invest, how much to invest, and perhaps even what to invest in (assuming all this is set prior). It's not surprising therefore that dollar cost averaging has its band of adherents