Investopedia describes Dollar-cost averaging an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. It is not a strategy that is exclusive to a mutual fund investment but it can have wider application and you will usually come across it in direct equity (stocks and shares) investments as well. However, we will primarily look at its application and importance when speaking about saving regularly through a mutual fund or a unit linked investment scheme. It is often referred to as dollar cost averaging (or pound cost averaging) but in the spirit of patriotism! and relevance we have gone with ‘kwacha cost averaging’
Saving through a mutual fund is typically intended to reap benefits in the long term. I know long term can be interpreted relatively, especially given our Zambian context. I once met someone who considered the thought of saving for retirement for over 10 years redundant, simply because of Zambia’s low life expectancy! Their argument was that they would probably never get to enjoy the benefits of their labour if they set up a twenty year retirement plan! Again, it is important to put things into perspective, and to be fair, it was probably a reasonable point to bring up because one must consider the context in which they are investing, i.e a low life expectancy nation like Zambia. However, the truth is that no one knows what the future holds, and this uncertainty actually is the main reason we must plan for the long term as well as the short to medium term. Both my sister and her husband are doctors. Consider for a moment what would happen if they happen across a formula that dramatically extends the average life expectancy here in Zambia and we find more people actually living to retirement age and beyond! Well, they haven’t (yet) discovered this life altering drug! However, the point remains, we must plan for the long term and it is this long term time time period that allows us to benefit from the two mechanisms that give you growth on your savings, namely, cost averaging and compound interest.
Our attitude to risk often determines whether or not we will go along with a particular investment and one of the main risks that we often perceive with investing through financial instruments like mutual funds is the volatility that comes with it. This is because at any given time, the value of your portfolio will simply be the number of units (or shares) you have purchased in a mutual fund multiplied by the price per unit/share at any given time. This means if the price goes up then the value of your investment goes up with it (happy days right?) and if the price per share goes down then the value of your investment also goes down with it! (Oh no! Right? Well, not exactly) This is where cost averaging comes in if you are saving into your mutual fund on a regular basis because it allows you to buy at the bottom of the barrel when markets/prices are low and reap the benefits when markets/prices are high! This means you are actually taking advantage of the volatility in the market rather than shuddering away in fear!
Let’s assume Chanda doesn’t want to keep all his money in cash in the bank and so every month from his monthly salary of ten thousand kwacha he sets aside two thousand kwacha to buy barrels of gas which he stockpiles in a warehouse in Avondale. The number of barrels he is able to buy each month is dependent on the price of gas when he is buying and the entire value of his warehouse will be the price of gas multiplied by the number of barrels he has. Let us assume that the current prevailing low oil prices translates to a cut in the price of gas here in Zambia. This would mean that Chanda will be able to purchase more barrels of gas with the same two thousand kwacha because of it but the value of his warehouse will also be low because of the low prices. However, should prices go up again, Chanda would be able to buy a fewer number of barrels with the same two thousand kwacha, but because he was able to buy a larger number of barrels when the price was low, the overall value of his warehouse is now much higher because of the price increase. Effectively, this means that those barrels he bought when the price was low would increase in value!
This, in a nutshell, is cost averaging, and is exactly the same concept that can be applied to a mutual fund. The units/shares in the mutual fund would be the barrels, the market volatility would be the price fluctuations and the portfolio value would be the warehouse value. Imagine Chanda did this for twenty years, after which he retired and decided to sell his warehouse! If the drivers delivering gas to the stations were on strike at the time then the laws of supply and demand would mean that Chanda would make a fortune! Thanks for reading.