This article was written by Raymond Pecotic, Managing Director of Empire Financial Group, and first appeared in The West Australian, Your Money, on 21 November 2022.
Most people know that keeping money in cash in a low-interest and high-inflationary environment will be detrimental to the long-term buying power of their capital.
But in volatile and uncertain markets it can be difficult to know the right time to take the plunge and enter the market.
The sale of a business or a long-held rental property, or receiving a redundancy or an inheritance can be a significant boost to someone’s wealth, but it can also create much anxiety.
Quite rightly, this money is often seen as life-changing and there is a tremendous weight of responsibility on the recipient’s shoulders to make sure they get it right and don’t mess up the opportunity to secure their financial future.
There are many ways to manage risk and gain comfort in these situations.
Of fundamental importance is constructing a portfolio that meets the needs of the investor — be that primarily for income, long-term capital growth, or a combination of both.
Becoming well-informed about the different asset classes and what to expect from them is also very important to gain confidence in your investment strategy. Surrounding yourself with the right advisers will be key to this journey.
Once you’ve got a better understanding of your options, considering how much risk you’re willing to take in exchange for returns — otherwise known as risk profiling — will determine your final investment mix.
But when is the right time to pull the trigger and buy into the market? With markets often moving multiple percentage points in a single day, how do you know which particular day you should invest the funds?
Get the timing right, buy right at the bottom and you will have secured an instant boost to your wealth. But buy at the very top and it could take many months, or years, for the value of your funds to recover.
The fact is that nobody can with complete — or even with moderate — confidence pick the absolute top or the absolute bottom of any market with pinpoint accuracy.
The accepted wisdom is to take a more conservative approach, and slowly ease money into the market, essentially smoothing out any wild fluctuations and buy the average price of the market over a period of time.
This concept is known as dollar cost averaging.
Taking this approach may mean that if you had, by some fortune, started your buying process at the bottom of the cycle, your overall average buyin would be higher than buying all at once. But it also means if you start the process at the beginning of a downward cycle, your overall purchase price is cheaper.
While buying the averages sounds like a reasonable concept and can provide extra comfort to investors, do the statistics support engaging in this process? Read the case study below to find out.
Put simply, the analysis found the more growth assets you have, the greater the chance of really stuffing things up by investing all at once.
It also points to one obvious conclusion — the times when DCA works best are when markets are stressed.
For those who have a low risk tolerance and don’t want to mess up investing a windfall gain, the conclusion is that DCA can mitigate the risk of severe negative outcomes and instil far greater comfort to investors deploying capital in unpredictable markets.
How we worked the sums
For the purposes of this dollar cost averaging study we engaged portfolio construction analysts from Perthbased experts Context Capital Consulting.
We’ve compared the dollar amount a lump sum of $100,000 would have grown to five and 10 years later using an invest-it-all-at-once approach versus a number of different dollar cost averaging strategies.
We carried out this comparison using a well-known benchmark conservative, balanced and growth fund for our investment portfolios, and using the Reserve Bank’s cash rate as an assumption for what the uninvested portion of the lump sum could earn before it is invested.
What can we say in general?
Most of the time — between about 60 to 75 per cent of our measured outcomes — investing your lump sum all at once results in a higher balance than using a dollar cost averaging strategy. This holds regardless of the DCA strategy used or the investment portfolio chosen.
On first read this may conclude that DCA is not a viable approach.
However, the benefits are skewed. Most of the time, you get modestly better outcomes from no DCA, but when it goes wrong it can go really wrong. That is, the worst case outcomes are much worse than the most positive outcomes are positive.
The most likely outcome is a small positive benefit from investing all at once, in this case of between about 0.5 to 2 per cent over five years. However, there is a greater chance of getting outcomes of worse than -7.5 per cent, with one outcome coming in worse than -10 per cent.
If you are purely playing the odds, you’d likely just always invest all at once. This assumes though that the only thing people care about is the end outcome. However, we know in practice that people value avoiding “bad” outcomes about twice as much as they do achieving “good” ones.
This becomes even more pronounced as the portfolios increase exposure to growth assets. For the same comparison as above, the difference between the best and worst outcomes for the conservative, balanced and growth funds were 9.4 per cent, 16 per cent and 23 per cent, respectively.