In light of the current volatility in the market, the question on every investor’s mind is: what investment strategies should be considered when navigating the stock market?
As an investor, you have access to a number of investment strategies. However, an experienced investor understands the importance of understanding and considering the dynamic nature and movements of the market in their investment approach.
Dollar Cost Averaging
One approach and the focus of this article is the Dollar Cost Averaging strategy. This is a method of investing that involves investing a fixed amount of money at regular intervals. This approach increases the probability of an investor buying more shares when prices are low and fewer shares when prices are high. Over time, this can result in a lower average cost per share, which can lead to higher returns in the long run.
Current Market Volatility
The Australian stock market has experienced significant volatility in the past few months. The S&P/ASX200 index, which serves as a benchmark for the Australian market, reached a 13-month high in late January, but since then, it has been on a downward trend due to concerns over rising inflation and interest rates. In February, the index fell by 2.4%, marking its worst monthly performance since October 2020. As of mid-March, the ASX 200 was down around 2% from the year-to-date, with investors keeping a close eye on the ongoing COVID-19 situation and global economic developments.
The market has also been impacted by the recent COVID-19 outbreaks and subsequent lockdowns in several states, which have led to a decline in consumer and business confidence.
What are the benefits of Dollar Cost Averaging?
So, the question is then posed, amidst the uncertainty and volatility within the market, what are the benefits of adopting the dollar cost averaging strategy as an investment approach?
- Mitigates the Impact of Market Volatility: One of the benefits of dollar cost averaging is that it can help minimise the impact of market volatility on an individual’s investments. For example, during the COVID-19 pandemic, the Australian stock market experienced significant fluctuations. However, investors who followed a dollar cost averaging approach were able to minimise the impact of these fluctuations on their portfolio. According to a study by Vanguard, investors who used dollar cost averaging during the 2020 market downturn saw a 40% increase in their portfolio value compared to those who did not use dollar cost averaging.
- Reduces the Risk of Timing the Market: Additionally, dollar cost averaging can help investors avoid the temptation to time the market. By investing a fixed amount of money on a regular schedule, investors can avoid the risk of investing a lump sum at the wrong time. For example, during the 2018 market correction, investors who used dollar cost averaging to invest in the ASX 200 were able to achieve a 2.2% gain, while those who invested a lump sum at the beginning of the year saw a loss of 2.8%, according to research by BetaShares.
- Increases the Potential for Long-Term Returns: Another benefit of dollar cost averaging is that it increases the potential for long-term returns. Through the accumulation of more shares at a lower price and fewer shares at a high price, this can result in a lower average cost per share over time, which can lead to higher returns in the long term. According to a study by Vanguard, Dollar Cost Averaging resulted in an average annual return of 9.8% for investors in the Australian stock market from 1926 to 2019.
What are the limitations of Dollar Cost Averaging?
Unfortunately, there are drawbacks involved with adopting the dollar cost averaging strategy and should be considered by investors. The key limitations are expressed below.
- Higher Transaction Costs: One set back of dollar cost averaging is that it can result in higher transaction costs for investors. Because dollar cost averaging requires the investment of a fixed amount of money on a regular basis, investors may need to make more frequent trades, which can lead to higher brokerage fees and other transaction costs.
- Opportunity Cost: Another limitation of dollar cost averaging is that investors can miss opportunities in the market. By investing a fixed amount of money on a regular basis, investors may miss out on buying opportunities when the market is down.
Ultimately however, as an investor you need to weigh up the pros and cons with your personal goals and objectives. Dollar cost averaging is a great strategy for investors looking for more stability in their long-term investments.
If you would like to better understand how this strategy can work for you or are looking to start your investment journey, click here to organise a complimentary 20-minute phone call with an EPG Wealth adviser.