Some people mistakenly think that dollar cost averaging is like “going double or quits”? But dollar cost averaging is not about gambling, nor about increasing the stakes – quite the opposite in fact.

Dollar cost averaging is a simple tool that investors can use in many different ways to reduce investment risks.

The concept revolves around the idea that none of us have a crystal ball and we can’t foresee the future. This of course is what makes investment decisions so hard – we don’t know exactly what is going to happen in the future, where property prices will go or what will happen to interest rates etc.

Let’s say we have $100,000 to invest in shares. Furthermore, we are unsure whether the current price of the shares is a good entry/acquisition price. If the shares are currently trading at $2 a share we could go and buy 50,000 shares right away. But if we do that and the price drops to $1.90 then we’ll have immediately “lost” $5,000 of our initial investment. But then again if we don’t buy now, next month the price might be $2.10 and our $100,000 will only buy 47,619 shares and not the 50,000 we could have got now.

In a situation like this we could decide to invest say $10,000 now, and a further $10,000 each month for a further 9 months. This strategy means that we won’t acquire all the shares at the top price, but we won’t acquire them all at the bottom price either. In other words we’re reducing risk. Let’s look at how the numbers may work.

The value of the shares at month 10 is $105,161 (50,077 shares at $2.10 each).

In the above example we would have done best by purchasing all the shares in month 3 when the price was only $1.85. We would have done worse by investing all our money in month 7 or 10 when the price was $2.10. By spreading the investment over 10 months the average acquisition price was $2.00 per share but we still did better than if we had bought all the shares for $2.00 in month 1. If we had done that we would only have acquired 50,000 shares and our investment at month ten would have been worth $105,000 and not $105,161.

In the above example we increased return and reduced risk by using dollar cost averaging.

So how can property investors apply the concept of dollar cost averaging to their investments?

Obviously, one way is to space your investments. If you buy a property say every two years you will buy some when prices are high, some when prices are low and some when prices are average. You would do better if you bought all your properties when prices are low (at bottom of a slump), and you would do worse if you bought all your properties during a high (at the top of a boom). By regular ongoing investment (and ensuring the numbers work in each and every case) you will in effect be dollar cost averaging your property investments and reducing the risk of buying only when the prices are high.

Another way that property investors can use the concept is in managing mortgages. If you refinanced all your mortgages at the relatively low rates of say 6% and fixed the terms of all the mortgages for say 5 years there is a very real chance that in five years time when the fixed term expires the interest rates may be in excess of 9.5%. That’s a jump of 3.5%. If you have borrowed heavily then this increase in mortgage interest rate applying to all your debt is likely to have considerable impact on your financial position. You may even be forced to sell some property if you can’t afford to service the mortgage at the higher rate.

If you had used the concept of dollar cost averaging, or “mortgage laddering” as it is sometimes called, you could have reduced the risk of this happening. For example, you could have put say 20% of your mortgages on 1year fixed term, 20% on 2 years fixed, 20% on 3 years fixed, 20% on 4 years fixed and the balance on 5 years fixed term. In this example while you would have paid more in interest over the five years you won’t have to refix all the mortgages at 9.5% or above at the end of the five-year fixed term.

People coming to NZ from overseas can also use the dollar cost averaging concept. When is the best time to bring your money over to New Zealand? The answer to this question depends on exchange rates and even the experts have trouble predicting where the kiwi is going. Try dollar cost averaging to minimise the risk of bringing it all back at the worst possible time.

Dollar cost averaging is about reducing risk, not maximising returns. If you think you can time a particular market that’s great – do it (and take the risk that you might be wrong.) If you’re not sure about the timing then you can hedge your bets and dollar cost average – you probably won’t be the best performer, but you’re unlikely to be the worst either.