Life is full of ups and downs it seems. One week we're cheering on the Wallabies and talking about how we could possibly make it all the way and then the next we're drowning our sorrows and playing for third place. Apple released and new iPhone and then we get the news of the passing of Steve Jobs. We experience the same highs and lows in the sharemarkets, although it seems a bit more than usual these days.

It is not easy trying to predict to top or bottom of the share market. If we look back historically who could have seen that the earth was going to start shaking in Japan and cause a nuclear catastrophe, that planes were going to fly into buildings in New York or even more recently that governments around the world were spending more than they earn? Ok maybe the last one is a little more topical but the point is that it is not easy to predict the highs and lows of the sharemarket.

Some of the worst examples of trying to pick the "right time" to invest would be after talking to friends and family around the BBQ on the weekend and acting on a "hot tip," chances are that the investment has already produced the return otherwise they wouldn't be telling you about it and that you're probably buying in at a higher price. Alternatively you may be watching the news and starting to panic from all the talk about debt and recessions and sell down to cash possibly at one of the lowest points in the market. Long term investors will understand that return will actually come from time spent in the market as opposed to trying to time the market. To try and understand this a bit more let's remind ourselves of the value of dollar cost averaging.

Dollar cost averaging is the investing of the same amounts of money over regular time periods. What we need to understand is that dollar cost averaging actually works a whole better in volatile markets than in steadily increasing markets. As investors we would like to see the return of the market of old just like that during 2003 - 2007. Who wouldn't? Put your hand up if you are tired of seeing ASX 200 bounce around 4000 points and 5000 points only to see it finish on where it first started? We can all agree that we a living in volatile times. So how does dollar cost averaging work for us?
Consider the following.

Let's say we look at an index fund and price of unit of that fund starts at $100, falls to $75, falls further to $55 before bouncing back to $110 and then finally settling back at $100. This means that over the five investment periods the value of the unit has gone up and down and then finished at where it started. The bad news in this example is that with dollar cost averaging at times you will be buying high but at other times you will be buying low.

In the above example if you were to invest $1,000 at each investment period then your portfolio would be worth $6,060.

In contrast let's say that the price was $100 and the price increased steadily by $10 over the same investment period and is now valued at $140 (arguably an investor's dream market) then if you were to invest the same $1,000 in those periods your portfolio would be worth $5,915. The average unit price of the dollar cost averaged portfolio was $82.51 compared to $118.34 for the steadily rising market.

The message here is that in times like these the discipline of a structured investment strategy like dollar cost averaging will help us overcome the behavioral bias that wants to turn us into market timers.

by Michael Sik

(example sourced from Vanguard Investments Australia)