When you purchase most listed investments, I can guarantee one of two things will happen: Its value will go up or its value will go down, and this will happen each and every day.
In developing any long term investment strategy, an issue that must be considered is risk. While there are many types of risk, one risk that is familiar to many investors is purchasing an investment at the wrong time. But when is the right time?
Some people say, “There’s no time like the present.” Others say, “We’ll just hold off and wait and see what the market does”. However, we know that the market will go up and down.
If you are looking to accumulate wealth over the longer term, you will see many highs and lows in the markets. There will be many good times, recessions, bears and bulls. It is impossible to pick the top and the bottom. We only know those with hindsight. And even in hindsight, it can at times take more than a year to establish what the actual top of the market is.
The below chart shows the All Ordinaries Index over the last decade. In February 2002, the All Ordinaries Index reached a high of 3,443 (see Point A in Chart 1 below). Then in March 2003, the index went down to 2,666 (see Point B). In November 2007, the All Ordinaries Index reached 6,873 (see Point C) and in March 2009 it was back down to 3,053 (see Point D). The All Ordinaries Index in February 2002 of 3,443 was not the top, because there was a subsequent increase in November 2007 to 6,873.
Australian All Ordinaries Index (XAO) September 1999 to 14 August 2009
Source: Google Finance
The next chart shows the share price of Commonwealth Bank of Australia (CBA) over the last decade. When you take a longer term view, say 10 years plus, it is likely that what is perceived to be a top in the market at a point in time will be exceeded in the future. For example, if you had purchased shares in CBA on say 14 February 2002, you would have acquired them at a price of $33.69 per share (see Point A in Chart 2). In November 2007, CBA shares reached $62.16 per share, and as at 11 August 2009, they closed at $45.43 per share (refer to Points B and C respectively). So if you had previously purchased the CBA shares at the “top” of the market in February 2002, I would suspect you would be very happy with this price in 2007 and even now.
Daily Share Price of Commonwealth Bank of Australia (CBA) September 1999 to 14 August 2009 (in Australian dollars)
Source: Google Finance
My point is that the investment markets are a fluid vehicle that constantly changes, so trying to pick the entry and exit points can be a futile strategy if you are taking a longer term view.
So if it is impossible to correctly pick the exact point of a bottom and top, what other strategies can we consider? One strategy is dollar cost averaging. Dollar cost averaging is where you purchase investments at regular intervals over a period of time, regardless of the price of the investment. Take the value of a share, let’s say CBA. The table below shows the price of one CBA share on the last day of every month for the period from 31 July 2007 to 30 June 2009.
End of Month Share Price of Commonwealth Bank of Australia (CBA) 31 July 2007 to 30 June 2009 (in Australian Dollars)
Data obtained from: Google Finance
If we invested $5,000 per month (total of $120,000) in CBA shares, over the 2 years we would have purchased 2,930 of shares, which at 30 June 2009 would have a value of $114,270, with an average cost of $40.95 per share. This average cost is less than the closing price of 13 months out of 24. Therefore, if we decided to make a single acquisition of $120,000 worth of CBA shares in any of those months where the stock price was higher than $40.95, we would have owned fewer shares.
Provided history continues to repeat itself, and as shown in the chart below for the All Ordinaries since September 1984, historically, after “market lows” it recovers to exceed the “market highs”. In a market that is consistently growing over the long term, by dollar cost averaging you will effectively drive the average cost of your investment down by buying more units when prices are down, and fewer units when prices are up.
Australian All Ordinaries Index (XAO) 4 September 1984 to 1 September 2009
Source: Yahoo Finance
Dollar cost averaging is an effective long term strategy used to manage entry point risk when buying listed assets. If you would like to discuss using dollar cost averaging as part of your investment strategy, please contact us on 07 3833 3999.