Thursday, 3 July 2008

The Importance of Dollar Cost Averaging

There seems to be bad news everywhere. Australian shares have sunk below 5000. This is the lowest I have ever experienced. All in all, I have lost about $4000 so far. I am not the only one who has done badly this year (see Buffett's Berkshire in Bear Territory and Enough Wealth June 2008 Net Worth Report). Because I am young and still just starting out in the world, I have relatively little money invested and therefore I have suffered smaller dollar losses compared to actual millionaires or even billionaires like Warren Buffett.

I went through some of the data today and looked at contributions I made to my mutual fund. I wanted to see whether I have been dollar cost averaging. To dollar cost average is to put in the same amount of money every month, e.g. investing $1000 per month. Dollar cost averaging helps smooth out the performance of your investments. Unfortunately I haven't been dollar cost averaging very well. The graph below shows how much money I put in (on the vertical axis) and how the value of the Australian share market (based on the All Ords) when I put money in. If I have been dollar cost averaging successfully then I should expect to see equal height bars everywhere. If there are high bars they should be dispersed across many different All Ords values.

The chart clearly shows many huge spikes when the share prices are high. The $5000 contribution was unavoidable because Vanguard requires you to have that much to start a mutual fund. However, instead of setting cash aside and dollar cost averaging like I should have, I noticed that the market was heading up and up in the early days and so I plunged everything I had into the mutual fund, creating the three other massive spikes you can see nearby. Then when I ran out of money I began to put in around $400 to $500 per fortnight, which was all I could afford given my part-time job. The $1500 spike at the lower end was when my brother repaid me money he owed me.

My plan now that the market is down is to do extra hours at work. After all, I have finished all my exams at university and I have secured myself a full-time job for next year. I have nothing to do but work. While the market is low I will pump in as much money as possible to try even out things. I will try to produce lots of high bars at the lower end of the graph.

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