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What Dollar Cost Averaging Really Does for You

Here at The Motley Fool, we often recommend putting money into stocks a little at a time, on a regular basis, through up markets and down. This is known as dollar-cost averaging, a popular strategy with long-term conservative investors. But as my own experience demonstrates, this sensible, lower-risk approach won’t always lead you to the best returns– unless you use it wisely.

How does dollar-cost averaging work?

Many banks offer monthly stock or mutual funds savings plans.  Investors contribute a fixed amount of cash – as little as HK$1,000  – every month, which the bank uses to purchase a selected stock or mutual fund.  When the stock’s price falls, that sum buys more units; when the price rises, it buys fewer. Over a long period of time, the cost of each purchase essentially “averages out.”

Besides the way it smoothes out the stock market’s bumps, these plans benefit investors with their low entry cost.  The minimum lot value of many blue-chip stocks in Hong Kong is way over HK$1,000.  But with plans like these, investors don’t need to fork out that lump sum in one go. The bank will pool your contribution with others to purchase the stock, sidestepping the lot size limitation.  It’s a bit like buying stocks in installment.

What could go wrong?

Sounds good, right?  I certainly thought so.

More than a decade ago, I subscribed to a monthly savings plan to buy JF Taiwan, a fund whose return mirrors the TAIEX.   I held on to this investment for 10 years, and finally sold it off last year.  How did it do?  My total gain from this investment was 5% over a 10-year period– or 0.49% per year.  So why did my investment end up with such unsatisfying returns?

1.    WHAT you buy matters, a lot

The stock or fund you select must be on a continuous uptrend over long periods of time.  If, instead oftheTAIEX, I bought theS&P 500, my investment’s return would have been much better.

2.    Volatility also matters

To really profit the price trend of your stock/fund should ideally come in multiple waves, with each peak higher than the last.  This means there will be enough volatility for you to buy at least some of your shares at a lower cost, and thus profit from the subsequent uptrend of the stock/fund. With TAIEX, that clearly didn’t happen.

3.    Check the transaction costs

As always, scrutinize each and every fee – initial, management, custodian, commission, etc. –that the bank and brokerage house will charge. This matters even more in a long-term investment plan, since these ongoing costs will eat into any profit you may make.

While dollar-cost averaging is straightforward, its performance is not. Averaging out the cost also means averaging out any loss and profit that the investment might generate. And if the selected investment shows no growth over the planned investment period, dollar-cost averaging could end up being much ado about nothing.

That said, dollar-cost averaging can be a useful tool to have in your investment toolkit. The choice of asset is critical – consider picking growth stocks that have long-term appreciation potential but short-term volatility.  Quite a number of internet stocks would fit the bill, for instance.  In the bigger picture, dollar-cost averaging investing can be a good supplement to conventional one-off stock purchases, as it evens out some volatility.  How much of your portfolio it should take up is then a matter of your risk appetite.  As long as you understand how it works, you can really have the best of both worlds!

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