When Soaring and Plunging Returns Are Good
By Mary Holm
Saving regularly - putting a fixed amount into, say, a managed fund every pay day or every month - is wise for more than one reason.
The obvious advantage is that it becomes a habit. After a while you don't miss the money. And even small regular amounts can accumulate to large sums over the years.
A less obvious advantage is that, if you're in an investment with fluctuating returns, you benefit from what is called dollar cost averaging. And the wilder the fluctuations, the bigger the benefit.
Hang on a minute. Aren't we supposed to be wary of investments with returns that soar and plunge repeatedly?
Well, yes. But many New Zealanders are too wary, sticking with investments that are, arguably, too safe. In the end, they accumulate less.
More on that in a minute. Let's look first at how dollar cost averaging works.
If you invest a fixed amount regularly, you will buy more units when the price is low, fewer when it's high. This means the average price you pay is lower than the average unit price over the period. Without having to work at it, you're getting bargain prices.
For example, you invest $300 a month. In the first month, the price is $15, so your $300 gets you 20 units. Next month, the price has risen to $25, so you get just 12 units. In the third month, the price drops to $20, so you get 15 units.
The average of $15, $25 and $20 is $20. But you've got a total of 47 units, for $900. That amounts to $19.15 a unit.
Now let's see what happens if the returns fluctuate more, from $10 to $30 to $20. In the first month you get 30 units; in the second, 10 units; and in the third, 15 units.
The average price is still $20. But you now have a total of 55 units, for $900. That's just $16.36 a unit - a much better deal.
Nobody, of course, expects prices to fluctuate that much over just three months. But it's easier to follow extreme examples. And over many years, prices certainly can move over a wide range.
An item in a recent Craig & Co newsletter gives a real-world example of how dollar cost averaging works better in a more volatile investment.
The firm looked at investments into various funds of $200 a month for five years ending January 1 this year.
The three fastest growing funds it studied were Electra and Gartmore European, which both grew by 37 per cent a year, and Invesco Japan Discovery, which grew by 33 per cent a year - all extremely good returns.
While the Japan fund had slightly slower growth, its returns were more volatile than Electra and Gartmore. And this made a huge difference.
An Electra investment would have grown to about $26,800. In Gartmore, it would be $24,700. But in Invesco Japan it would be almost $54,000 - more than twice as much.
OK, you might say, but I'm not game to try a volatile Japanese fund.
You could, though, consider moving your long-term regular savings from term deposits to a managed fund that invests partly in shares. Or, if you're already there, try a fund that invests only in shares.
The more heavily you are into shares, the higher your long-term returns will probably be.
The returns will also be more volatile, which can be worrying to some people. But, as we've shown, the more the returns fluctuate, the more you will gain from dollar cost averaging.
Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached by E-mail at email@example.com. Sorry, but she cannot respond directly to readers.
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