Let's face it, there's no crystal ball telling us when to buy shares. Thanks to Hollywood, there’s a false perception that the best investors throw all their money in at the exact right moment and then cash out again at the exact right moment.
In reality, it’s virtually impossible to time “exact right moments”, and people who do get it right sometimes, are wrong just as often (if not more). The good news is that there are ways to shield yourself from share market fluctuations and take timing out of the equation. One way to do it is through dollar-cost averaging.
How does dollar-cost averaging work?
Dollar-cost averaging is when you invest the same amount of money in a company or fund at regular intervals. Instead of watching share prices tirelessly for months and months to try and calculate the best time to buy, dollar-cost averagers find a good investment (one they expect to be worth more in the future) and then keep investing in it at regular intervals over a long period of time.
For example, say an investor buys $300 of Netflix shares every month. In the months where Netflix’s share price is low, they’ll get more shares for their $300, and in the months where the price is high, they’ll get fewer shares. Since they get more shares when the price is low, the “bargain prices” will bring down the average price per share that they pay over time.
So, let’s pretend you've found an exchange-traded fund (ETF) you want to invest in. You could wait and hope you guess correctly when the price hits rock bottom, then scoop up a bunch of shares at once... Or you could dollar-cost average your investments over time.
Let’s say you opted to invest $200 every month:
Over 5 months:
The average share price was $49.20 - Add the monthly prices and divide by 5
The average price you paid was $48.31 - Because your monthly $200 bought more shares when the share price was lower, the average price you paid is lower than the overall average price (divide the $1,000 invested by the 20.698 shares you own).
By investing a fixed dollar amount, rather than buying a fixed amount of shares every month, you have wound up with more shares!
But wouldn’t it have been better to buy all your shares in month 1 when they were cheapest?
Sure. But it’s equally likely that you’d have seen the $40 price tag in month 1 and thought “oh I’ll wait for a better deal” - then panic bought in month 2 when the share price was higher than the average you’d pay by dollar-cost averaging. All share prices cycle through highs and lows, and trying to guess the top and bottom is much harder (and usually less effective) than riding out the waves and getting those lows to decrease your average price.
But what if the price is steadily going down? Should I stop?
Dollar-cost averaging removes the emotion from investing (loss aversion is real!). While your lump-sum investor friends will be watching those charts on the daily and panicking at every price drop, you can go about your life and leave your investments to do their thing.
Obviously, when a company’s shares drop in value, it’s easy to worry that there’s something wrong with it. This is why it always pays to believe in the company you’re investing in. If you think it’s a solid investment, a lower share price shouldn’t change that. This is actually an important point because fear is an investor’s worst enemy.
One of the reasons dollar-cost averaging is a popular way to invest in ETFs is because your investment dollars are often spread over an entire industry or economy. If the S&P 500 drops in value for a year, as long as you believe that eventually, the entire US economy will improve, you can keep buying shares on the cheap and ride it out. It’s a lot easier to believe in the future of an entire economy than the future of just one company!
How else can dollar-cost averaging help me?
When investing in the US share markets, you’re not just dealing with share price fluctuations, you also have exchange rates. Exchange rates are just as hard to predict as share prices - and they’re just as vulnerable to news and presidential tweets.
Just like you can invest in shares regularly to smooth out share price fluctuations, you can also set up regular deposits to smooth out exchange rate highs and lows. Let’s pretend you also chose to deposit money into Hatch every month:
When you regularly exchange money from NZD to USD, you’ll smooth out the highs and lows and removes the risk of depositing a lump sum the day before the exchange rate improves (and winding up with less to invest). Yes, in some months, you’d have been better off to deposit a lump sum, but, as we’ve learned the chances of you correctly picking those months is quite low!
Because the Hatch exchange fee is a percentage on the exchange rate, it also doesn’t matter how little you deposit each time, the fee is just a small portion of your deposit.
If you are new to investing, we have a helpful FAQ full of resources to help you get up and running. You can also sign up to our free Getting Started Guide. In just 10 minutes a day for 10 days, we’ll walk you through everything you need to know to make your first share market investment.