2.3 Methods of Investing and Dollar Cost Averaging

Three Ways to Invest

Lump sum – the study guide calls it the most common method. Over time the unit price is expected to reflect accumulated and compounded returns, but if returns are negative the investor may get back less than invested.

Reinvestment – some Scheme Providers reinvest distributions automatically under a standing instruction; others give extra units through a unit split. Either way the compounding effect is the same.

Regular savings – contributions are not contractual and can be stopped at any time without penalty. This disciplined, flexible approach is the same principle that underlies EPF retirement saving, and it lets people with small capital participate with a low outlay.

Dollar Cost Averaging

Dollar cost averaging means investing a fixed amount of money at regular intervals, whatever the price. Because the amount is fixed:

• when prices are low, the money buys more units;
• when prices are high, it buys fewer units.

This can bring the average cost per unit below the average price over the period. The rationale is that hardly anyone can consistently invest at the bottom of the market, so most small investors are better off investing regularly through all stages of the cycle.

The study guide compares two investors who each spend RM30,000:

• Investor A buys a fixed number of units (1,000) every period, so the amount spent varies.
• Investor B invests a fixed ringgit amount (RM6,000) every period, so the number of units varies.

Falling market

Average cost: A = RM30,000 ÷ 5,000 = RM6.00; B = RM30,000 ÷ 6,850 = RM4.38. B holds 1,850 more units, which pays off if prices recover.

Rising market

With the same prices in reverse order (RM2 up to RM10), the totals are identical: A still averages RM6.00 and B RM4.38. B keeps the cost advantage.

Fluctuating market

A's budget runs out after four purchases: average RM7.50. B averages RM30,000 ÷ 6,350 = RM4.72. The study guide notes that the benefit is even more marked in a fluctuating market.

The Formula to Use in the Exam

$$\text{Average cost per unit} = \frac{\text{Total amount invested}}{\text{Total units bought}}$$

Compare it with the simple average of the prices paid. Example: RM300 invested in each of three months at RM1.00, RM0.75 and RM1.50 buys 300 + 400 + 200 = 900 units for RM900, an average cost of RM1.00, below the average price of (1.00 + 0.75 + 1.50) ÷ 3 = RM1.0833.

Caveats

• Dollar cost averaging helps but does not guarantee good results. In the falling and fluctuating examples both investors lost money because the final price was below their average cost.
• Its real value is the commitment to regular investing: buying more units when fear is greatest, and avoiding the need to time the market.
• It should be used over long periods to get the full benefit.

Lump Sum or Regular Savings?

A Consultant should match the method to the client's cash flow and temperament. A client with an inheritance who is nervous about markets might combine a smaller lump sum with a regular monthly top-up, gaining some immediate exposure while averaging the rest.