In my previous article where I illustrated the effect of starting an investment journey prior to a bear market I touched on the idea of dollar cost averaging. In this article I wanted to discuss the idea in more detail and illustrate the effect of using it to construct a portfolio in a falling market.
In following example this portfolio will invest $1000 each quarter for 10 quarters into the All Ordinaries index. The table below illustrates the results.
Observe how the number of units purchased increases as the price of the stock decreases. Because of the fact that the cost base is calculated using the following equation:
this means that average unit cost (cost base) of the portfolio is more heavily skewed towards the lower priced unit purchases. The following graph shows the closing prices and the average unit value displayed in a graphical format. Observe how as the unit prices fall the cost base of the portfolio follows suit but with less volatility.
From the graph and table we can see that for our sample period that All Ordinaries have fallen 28.69% (6779 to 4834) however the cost base of the portfolio (4728.88) is actually less than the final market price of 4834 on the 1/4/2010. So this implies that dollar cost averaging has been able to eliminate the losses for this portfolio.
Conclusion
In falling markets dollar cost averaging helps to bring down the cost base of a portfolio through the mechanism of purchasing more units at lower prices. This, in turn, reduces the severity of the losses of the portfolio. The easiest way to apply this in the real world is to set a time period and choose an appropriate amount to invest. At the FFE house we choose to do it monthly as it coincides with my pay cycle.
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References
Yahoo finance, 2019, ALL ORDINARIES (^AORD), last accessed 3/1/2020, <https://finance.yahoo.com/quote/%5EGSPC/history?period1=-631180800&period2=1565884800&interval=1mo&filter=history&frequency=1mo>