The global equity markets are volatile and will stay that way for a long time to come. This is the perfect environment for savings plans. Their main benefit is that they allow the investor to take advantage of that volatility (no matter how negative).
For example:
An investor buys 300 units at a dollar each. At the end of the first month the price stays the same. In month two, the price drops 50% to 50 cents but returns back to $1.00 at the end of the third. Obviously the price stays at $300.
The savings plan scenario with a $100pm contribution over 3 months works as follows:
Month One: 100 units @ $1.00
Month Two: 200 units @ 50 cents
Month Three: 100 units @ $1.00
The total is 400 units with a value of $400.
By contributing monthly, an investment which ultimately stayed at parity as a lump sum, made a 33% profit. The profit was made by buying the lows at discount. Buying into a 50% drop, became a 100% gain ($1.00-50 cents-$1.00) for that contribution when the units were back at $1.
Below is a chart which explains unit purchasing at discount with dollar cost averaging very succinctly. Please click to enlarge.
However, the reason why dollar cost averaging models never outperform lump sum is that there is a point when the capital value of the investment just becomes too big. This is where most savings plans lose momentum. A ten percent loss on a $50,000 investment cannot be easily averaged by a $1,000 pm premium. Therefore, to manage a monthly savings plan is to manage two investments, the capital amount and the monthly contribution.
However, the reason why dollar cost averaging models never outperform lump sum is that there is a point when the capital value of the investment just becomes too big. This is where most savings plans lose momentum. A ten percent loss on a $50,000 investment cannot be easily averaged by a $1,000 pm premium. Therefore, to manage a monthly savings plan is to manage two investments, the capital amount and the monthly contribution.
Too often, I see a portfolio which has had some success, be debased because the capital was not managed correctly. There sometimes appears to be a fear of switching profitable funds to cash in order to protect the capital.
I do not have that fear. My first job is always to preserve capital. I will sell units in funds that I consider under pressure, if the capital value of the investment is under threat. But I may also buy into those same funds (or an alternative) with the next monthly contribution in order to start a new profit dynamic.
Managed correctly, monthly savings plans are incredibly powerful investment tools. Every investment programme should have one as part of its long term strategy. It is the most efficient method of taking advantage and profiting from volatility and negative market movements.
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