Dollar Cost Averaging
Broadly speaking, there are two types of investing: systematic and non-systematic. The first is a methodical approach and does not rely on one’s emotions or gut feelings. You put a fixed amount into the fund every month, regardless of market behaviour and the price of units. If the price of the fund goes down, you buy more units; if it goes up, you buy fewer units.
This approach is called ‘dollar cost averaging’. Simply it means that your average unit cost will be less than if you made an equivalent lump sum investment at its unit cost. Put another way, as prices fluctuate, you get more units.
The statistical effect becomes more obvious over time, especially in volatile markets, as the illustration below shows.
When emotion rules
Each year Dalbar, Inc. publishes an analysis of the effect on performance of investors’ buying and selling of US mutual funds. Although the numbers vary from year to year the message remains the same: the average investor earns significantly less than mutual fund performance would suggest.
Why is this? The answer lies in market timing. We all flatter ourselves that we can spot the right moment to enter or exit the market. In practice luck, mostly bad, plays as much a part as skill. Indeed, while the age-old advice to buy low and sell high is simple and obvious, our very unsystematic behaviour leads many of us to do the opposite.
Dalbar shows that over the 20 years ended 31 December 2007, the average equity fund investor would have earned an annualised return of just 4.5%, underperforming the S&P 500 by more than seven percentage points per year! Furthermore, $10,000 invested in equity funds in proportion to actual flows would have earned just $14,011, compared to $21,036 from a systematic approach that spread the $10,000 investment evenly over the 240 months (see chart). So your best course of action is to invest regularly and stay invested.