Dollar Cost Averaging

How should you handle the money you have for investing each month?

You have two choices: You can either place each small monthly accumulation into a bank account until you amass a substantial sum (which you will then invest), or you can invest each small accumulation every month as you obtain it.

Given these two strategies, which do you believe is the correct approach?

(a) Collect your monthly savings in a bank account and invest it after you have accumulated a substantial sum

(b) Invest each month's accumulation as you collect it

(c) Do some of (a) and some of (b)

(d) Sometimes do (a) and sometimes do (b), depending on circumstances

The correct answer is (b). It is so clearly the correct answer that it even has a name: Dollar Cost Averaging. Here's why you should practice it.

Say you have $100 and you buy an exchange-traded fund which costs $10 per share. That means you buy 10 shares. Next month, you save another $100, which you place into the same ETF, only now the shares are just $5. Thus, you buy 20 shares. What's the average price of all your shares?

Dollar Cost Averaging

 

If you said $7.50, you're wrong.

You invested $200 ($100 per month over two months) and you own 30 shares (you bought 10 shares, then 20). Divide $200 by 30 shares and you'll find that the answer is $6.67.

Why did you think the answer was $7.50?

Because you used the arithmetic mean ($10 plus $5 divided by 2 = $7.50.) But I used the harmonic mean ($200 by 30). Thus we're both right — the average price is $7.50, but the average cost is $6.67. Since the harmonic mean always produces a lower number than the arithmetic mean, you have a built-in profit!

Dollar cost averaging works because it acknowledges that we're all clueless when it comes to the stock market. Should we buy at its high of $10 a share? Of course not, but we're too dumb to know that the current price is destined to be the high, so we buy it. Thus, dollar cost averaging protects you by saying, "Okay, you dummy, if you insist on buying at $10 a share, I'm not going to let you buy very much."

Later, when the price goes down to $5 a share, DCA says, "Hey, you dummy, now's the time to buy!" so it forces you to buy lots of shares. In other words, DCA has you buy relatively few shares when the price is higher and more shares when the price is lower, thus giving you the average lowest cost. And since the average lowest cost is lower than the average lowest price, you're in a great position to enjoy a profit.

Thus, dollar cost averaging succeeds because you buy fewer shares at higher prices and relatively more shares at lower prices. To make it work for you, simply invest a specific amount of money at a specific interval. Perhaps $25 per month, $500 per quarter, or $5,000 in an IRA each year. It does not matter as long as you are consistent. Be sure to invest at each interval regardless of what the stock market is doing at the moment.

In fact, dollar cost averaging helps you overcome your fear that you'll invest at the top of the market. If you had invested $1,000 in the S&P 500 on January 1 of every year from 1974 through 2009, you'd have earned an average annual return of 10.6%. But if you got really lucky and were able to make your investments on the one day each year when prices were at their lowest, you'd have averaged 11.2% instead. But, knowing your luck, it's more likely that you'd have picked the worst day to invest each year. If so, your average annual return would have been 10.1%.

As you can see, it doesn't much matter when you invest when you dollar cost average. It only matters that you do invest and that you stay invested. "Timing" doesn't matter — "time in" does.

Two Problems and Two Tips with Dollar Cost Averaging

There are two problems with trying to implement dollar cost averaging correctly — and you're the cause of both of them.

Problem #1: When the Price Goes Down, You Won't Want to Buy More

"Why should I keep buying this dog?" you'll ask, allowing your emotions to defeat you. Therefore, when dollar cost averaging, never follow the daily prices; doing so will only upset you and prevent you from doing what you need to do to achieve financial success. Just buy your shares and ignore the rest.

Problem #2: You May Fail to Follow Through

It is vital that you stick to your plan. Too often, people simply forget to keep it up, what with life's everyday hectic schedules and all. Don't let anything stop you from fulfilling your DCA obligation on schedule.

To help you, sign up for automatic checkbook debiting. Through ACD, a pre-authorized amount will be withdrawn from your bank checking account and deposited into your investment account.

To help you establish a successful DCA strategy, follow these two important tips:

Tip #1: Invest in Stock Funds, Not Individual Stocks

Do not invest in individual stocks or you run the serious risk of mistakenly engaging in the dangerous practice of dollaring down instead of dollar cost averaging.

Case in point: On a tip from his uncle, one of my clients once bought a stock at $6 per share. When the stock later dropped to $4, he bought more. ("If I liked it at six," he figured, "I ought to love it at four!") When it dropped to $2.50, he bought more and even more when it dropped to $1. Soon after the stock became worthless, Forbes ran a story disclosing that the stock was an alleged front for the Mafia. By that time, my client had lost $33,000.

You see, when a given stock begins a significant sustained downward spiral, there's often a good reason — with no assurance that the price will ever recover.

Yet for dollar cost averaging to succeed, the price must recover. This is why you'll have better success with DCA via a mutual fund or exchange traded fund instead of with specific stocks, because if a given stock is on a permanent downward trend, the fund manager can dump the stock and replace it with another. Thus, although a given stock might never recover, the fund can, preserving DCA's effectiveness.

Tip #2: Choose the Most Volatile, Speculative Investment You Can Find

The best choice for DCA, and this might surprise you, is a fund whose price tends to swing to great highs and lows. Ordinarily, we'd dismiss funds with such high volatility as too risky, but when you're using DCA, this risk plays to your advantage.

Why? Because DCA's success is based on the efficient accumulation of shares. That means you need an investment which can drop in price, for the bigger the drop, the more shares you accumulate and the better your efficiency. After all, if you use a bank account, dollar cost averaging won't make any difference.

Thus, you should choose an investment (such as a U.S. or international stock fund) that experiences dramatic swings in value. If you are using DCA in such a fund, you'll actually celebrate when the stock market crashes! Investors who were dollar cost averaging throughout the 2008 recession certainly did: Since these investors were buying each month anyway, the 45% drop in stock prices gave them the chance to buy on sale! Remember, the only people who get upset during market crashes are those who are selling — not those who are buying!

Originally published in 
The Truth About Money

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