Why Dollar Cost Averaging?

How do you invest new cash?  Do you immediately jump into the market any time you receive a monetary windfall?  Or do you patiently horde cash waiting until you think the market is low enough to buy in?  If you’re attentive to the market, this may be your preferred method.  The effectiveness of these “lump sum” methods can vary significantly.

But there is another way to invest: systematic investing.  Many individual investors subscribe to this method by making periodic moves into the market.  We’ve alluded to this method before.  Transferring a portion of your paycheck into a predetermined investment removes much of the worry from the investment process.  To illustrate, check out this helpful Savings Calculator.

Since most investors use systematic investing through a 401k plan or other retirement plan, it would be beneficial to explain the rationale.  One type of systematic investment plan is dollar cost averaging, sometimes referred to as a “constant dollar plan”.  Dollar cost averaging is a potential way to smooth out market fluctuations on the cost of an investment.  The normal method involves setting aside (usually) monthly income to invest in stocks, ETFs, mutual funds, or other investments.  The cost of your investments varies over time so you rarely pay the same price for shares.

This can be beneficial.  One result of dollar cost averaging can be that you buy more shares when the price is low while fewer shares are purchased at higher prices.  This happens due to the cyclical nature of the market.  In a rising market, your average cost per share is lower than what they are currently worth.  In a falling market, your average cost per share may be lower than the average share price – but is often still better than lump sum investing at the beginning of the year.

The following chart illustrates dollar cost averaging with mutual fund shares in a fluctuating market.  In this example from Wells Fargo, a lump sum investment is compared to a dollar cost average strategy using a $1,000 investment per month.  The link provided also gives informative examples of how both strategies perform in hypothetical rising markets and falling markets.

Period

Monthly Investment

Share Price

Number of Purchased Shares

Cumulative Account Value

1

$1,000

$13.55

73.80

$1,000.00

2

$1,000

$12.20

81.97

$1,900.37

3

$1,000

$11.35

88.11

$2,767.97

4

$1,000

$10.90

91.74

$3,658.22

5

$1,000

$10.00

100.00

$4,356.17

6

$1,000

$10.75

93.02

$5,682.88

7

$1,000

$11.65

85.84

$7,158.66

8

$1,000

$11.95

83.68

$8,343.00

9

$1,000

$12.50

80.00

$9,726.99

10

$1,000

$12.95

77.22

$11,077.16

11

$1,000

$13.55

73.80

$12,590.39

12

$1,000

$14.05

71.17

$14,054.98

Total

$12,000

$12.00 (avg price)

1,000.35

$14,054.98

 

You can run different examples using different investment amounts.  Here’s another helpful calculator that contrasts lump sum investing and dollar cost averaging.

As you will see at the links provided, dollar cost averaging can be an effective and useful strategy in optimizing performance, but certainly not always.  It’s not a magic bullet.  A credible argument can be made that lump sum investing can be effective as well, especially if you can find the low point of a market that is ready to start going up.

Still, there are three important benefits to dollar cost averaging.  First, you’re saving – always a good thing.  Second, you’re NOT over-thinking the timing of your investments, often a losing proposition for many investors.  By avoiding enormous investment decisions about when to make lump sum investments, you preserve your mental energy for life’s other concerns.

Finally, by investing systematically, you can overcome the natural inclination to procrastinate. Most importantly, you’re establishing good investing habits – a challenge we all face.  For most, it’s a good plan to save a portion of your income, invest systematically, and take advantage of a cyclical market by dollar cost averaging.

If you have a lump sum to invest, dollar cost averaging is an important option to discuss with your investment professional.  The results can be surprising.

Comments

One Response to “Why Dollar Cost Averaging?”

  1. Tweets that mention Why Dollar Cost Averaging? | Invest With An Edge -- Topsy.com on June 7th, 2010 4:26 pm

    [...] This post was mentioned on Twitter by Dollar Deals, Ron Rowland. Ron Rowland said: Dollar cost averaging. It's been around for decades (probably longer) and still works. http://bit.ly/cOyDuP #mkt [...]