16 April 2021
Dollar cost averaging: What is it, and how does it work?
When you invest in shares, you have one main goal in mind: Make the money grow.
In saving money for retirement, you want to see as much growth as possible. The more money you are able to accrue in your superannuation fund, the more comfortable you will be when you finish working.
There are many ways to invest your money strategically, and there is no one right method. Some people buy a variety of low-risk shares to target small but sure growth, while others take high risks or create a diverse portfolio. At Active Super, we have investment options to suit everyone.
One thing that every investor should know about, however, is dollar cost averaging (DCA) and how it can benefit them.
Investing is, in many ways, unpredictable. The values of shares change from day to day, sometimes drastically.
There are ways to predict how the value of a share will change, for example by keeping up to date on company reports, observing changes in leadership and monitoring new innovations within the company. However, what determines the value of a certain investment is the ratio of buyers to sellers, which can be difficult to ascertain.
When more people are buying shares of a business than selling, that is considered a ‘good’ day for that particular stock, whereas when more people are selling than buying, that is a ‘bad’ day. When investing, you want to buy shares on a bad day because the price is lowerand you end up with more shares for the same amount of money as you would have on a good day. However, the dilemma is, how do we know when it will be a ‘bad’ or ‘good’ day?
DCA is the process of investing equal amounts of money in a particular investment at regular intervals. It’s a way of averaging out the price of buying shares rather than worrying if it’s a ‘bad’ or ‘good’ day and not getting as much as you can out of your investment.
When you spread your investment across multiple days, weeks, months or years, chances are some of them will be good and others will be bad, and you will average a higher return than you would if you invested all of your money on one particular day.
DCA takes some of the pricing risk out of investing. It’s a great option for people who do not want to play with fate while saving for retirement. The good news is, you’re already dollar cost averaging in your super.
DCA vs. lump sum
When you invest a lump sum of money into a particular investment, you’re hoping that the day you choose to do this is the ‘right’ day and you get the best return on your investment possible.
If you’re a market expert and you do enough research to bring you to a reasonable conclusion that the day you buy the shares is the ‘right’ day, this could be a sound investment. However, the market can be unpredictable, and even with all of the right tools and expertise, you face risk when investing a lump sum.
For the many Australians who do not study market trends and who want to incur as little risk as possible when saving for retirement, DCA is a great route to take.
It’s an especially excellent strategy when you start early. By beginning to invest sooner rather than later, you lengthen the time period over which you invest in a particular investment. The longer time period you spread your investment, the more your money can grow. Your money starts to earn returns, and then the returns start to earn returns. This is also known as ‘compound interest’.
A modern example
These hypotheticals might make more sense if we bring them to life with some examples.
Picture this: An Australian worker, let’s call him Joe, decides to begin saving for retirement at the age of 25. Already, we can tell that Joe has a good head on his shoulders.
Joe decides to invest in a promising Australian industry. He considers his options: Invest a large portion of his savings now and hope for a high return, or invest $50 per week for a long period of time.
Joe decides to go with DCA. For ten years, he buys $50 worth of shares in the company every Friday. Once a week for ten years comes out to about 520 separate purchases.
When looking at these 520 days, some days were good and some days were bad, with a lot of days in the middle. Therefore, on average, this was a sound investment with a good return, especially considering that he started early and consistently saved and reinvested money for ten years.
At the age of 35, Joe tells his friend Tom about his wise investment decisions. Tom has never invested his money, but he wants to make it grow just like Joe did. He figures that by investing the same amount of money that Joe invested over the years, which is approximately $26,000, he can catch up to Joe’s return on investment quickly.
However, little does Tom know, that’s not how investments work. While Joe invested on some bad days, he also invested on many good days, and he ended up with steady and reliable gains.
Tom, however, happened to invest his lump sum of money on the ‘wrong’ day. He did not end up with as many total shares as Joe did, and therefore, his return is much lower.
How Active Super can help
We aren’t saying that if you make the same decision that Tom did, your investment will be bad. The point we want to make is that the market can be unpredictable, and DCA is a smart way to mitigate some risk, especially when you start early.
Superannuation uses compounding interest to grow your balance which will help you in retirement. Building your super can be simple and even small things you do now to boost your super balance can reap rewards later. At Active Super, we believe in smart investments that are tailored to your goals and the amount of risk you are willing to take. Our financial experts can help you invest your money exactly the way you want so that you can have the retirement you’ve always dreamed of.
Contact us today to learn more about dollar cost averaging and how to grow your super.
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