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An Introduction to Dollar Cost Averaging

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January 23, 2018
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January 24, 2018

Basic understanding

12 hours      Beginners

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The earlier you invest, the better off you will be come time for retirement. The increase in time obviously gives your investments time to grow and take increased advantage of tools like compound interest rates. Starting investing earlier also means you will have more time to understand various investment strategies and take advantage of them.

One such investment strategy that helps reduce the risk stemming from market volatility is dollar cost averaging, also known as the constant dollar plan or pound-cost averaging. Dollar cost averaging can be a useful investment strategy if you are trying to maximize the dollar-to-share average of your buying and also wish to minimize some of the risk involved.

An Overview of Dollar Cost Averaging

Dollar cost averaging is done by deciding on a sum you wish to invest in the market and then meeting that sum by investing a portion of the amount at regular intervals. Maybe you plan to spend $30,000 overall; you could portion that out at a speed of around $1500 a month.

Investing your money over a period of time rather than all at once means that any sudden drops in the market will not have as detrimental an impact on your investment sum. This works better in markets known to have temporary declines. A set amount of money per month also means that you will be buying more shares when the price is low and less when the price is high, often lowering the average cost per share of your investment as well.

An Example of Dollar Cost Averaging

Let us say you are investing in a mutual fund and you are planning on investing $500 a month for the next ten months. We can look at the first five of those months and get an idea of how this method is utilized.

Month 1:
Money Invested: $50
Cost of Share: $20
Number of shares purchased: 2.5

Month 2:
Money Invested: $50
Cost of Share: $21
Number of shares purchased: 2.3

Month 3:
Money Invested: $50
Cost of Share: $19
Number of shares purchased: 2.6

Month 4:
Money Invested: $50
Cost of Share: $17
Number of shares purchased: 2.9

Month 5:
Money Invested: $50
Cost of Share: $21
Number of shares purchased: 2.3

In this case, a lump sum of $250 at month one would have resulted in 12.5 shares. While the regulated method resulted in 12.6 shares. This is a limited example, but you can see where the advantages are.

Let’s say in Month 3 the price per share took a huge hit and never recovered and Month 3-5 were all at about $12. If you had invested everything in Month 1, you would have lost $100 of the $250 investment. With Dollar Cost Averaging your losses would be at $45!

Common Dollar Cost Averaging Mistakes

  1. Not Taking Advantage of the Method While Young.
    • Dollar cost averaging provides the most benefit to those with many years ahead of them. The idea of a low monthly amount being invested is excellent for those with smaller incomes, and the ability to reduce risk and maximize cost-effectiveness is also nice for long-term investing.
  2. Not Sticking to the System
    • If you want the method to work, you can’t let market volatility scare you away, and you can’t be flaky with your investments. It is a game of averages, and you have to show up to win.

Detractors to Dollar Cost Averaging

“People do dollar cost averaging because they have the regret of making one big mistake. But the fact of the matter is that, mathematically, the market rises more of the time than it falls. It falls, but it rises more of the time than it falls.” – Kenneth Fisher

This method is not without its detractors. Besides the obvious downsides of missing out on big market upswings early in your strategy, both Time.com and CNN have pieces knocking this investment strategy. The piece at CNN cites this study by Gerstein, Fisher & Associates Inc. which states that “research suggests that a buy-and-hold strategy …results in higher expected returns and lower risk compared to a DCA strategy… theoretical and empirical data demonstrate the inferiority of DCA investing compared to LS [Lump Sum] investing and BH [buy and hold] strategies.” They argue that the fact the method helps dissuade some guilt from investors due to its risk averse nature plays with our psyche in such a way that professionals still suggest using it although all evidence seems to point against its effectiveness.

This demonstrates that whenever you are dealing with investment theories, you can have mountains of evidence and professional analysts, some telling you what you are doing is genius, the others that it is and foolish.

The Takeaway:

Always do your own research and calculations and find a strategy that meshes well with your life goals and retirement plans. Weigh potential returns against your tolerance for risk. If you fear a drop or want to reduce risk, then this can be a viable strategy.

You can use this Retirement and investment Income Calculator provided by Vanguard to help you start making your investment plans today.