Hi, this Quick Concepts series offer foundational financial planning techniques in a digestible format. Today we're talking about Dollar Cost Averaging and it's evil cousin Dollar Cost Ravaging.
Dollar cost averaging is the process of putting a regular amount of money into your investments on a consistent basis. $600/month for example. When the markets drop and prices are low, your $600 buy more of your chosen investment than when prices are high. In short, you're buying more at low prices and less at high prices, averaging down the cost of your investments. Most people have some fear of market volatility, but with dollar cost averaging you're using the volatility to your advantage.
You do this in the way that you shop. We all love a sale and we're more likely to things that are on sale and we're less likely to buy things when prices are higher. Now unfortunately people tend to do this backwards. We love to buy investments that have just gone up in price. It's very common for us to let our cognitive biases get the better of us and we chase that investment performance. When you make a regular monthly contribution you don't have to think about that and dollar cost averaging works automatically in your favour.
Dollar Cost Ravaging is particularly important to a retiree because it's just the opposite. When you're taking out that $600/month to fund your retirement lifestyle the volatility in the investment you own will work against you. So you really have to pay attention to how volatile an investment is and the choice is very different when you're putting money in than it is when you're taking money out.
So how can you take advantage of this information? If you're in your saving years then you may want to make your contributions to a highly volatile (but diversified) investment. Choosing something with a high equity content can be beneficial as money is contributed to the investment. If you're not comfortable with that much risk in your portfolio, then move the money to something more in line with your comfort zone over time.
If you're in your retirement years then do the opposite. Secure the money that you will need in the short term in an asset that isn't volatile - even something as simple as a high interest savings account is suitable. Then the rest of your investments can continue to be invested at your comfortable risk tolerance. From time to time when the market is in good shape, just shuffle some money from the investments to the savings to ensure you don't run dry.
A good relationship with a financial planner can help you remember to do this over time. If you'd like to learn more, please click the button below to book a time to chat.