Benefits of Dollar Cost Averaging

I know it sounds like a scary financial term, “Dollar Cost Averaging”, but it really is a good technique for everyone to practice if you have an IRA or some other form of a retirement account.  Chances are, if you are currently enrolled in an employer 401(k) and the like, you are probably already doing this.  Essentially, dollar cost averaging involves buying a few shares of your investment each period whether the asset is up or down.  Over the course of time, your average purchase price will hopefully be less then the current stock value.

Let’s put a concrete example together to help explain this scenario.  Say you’ve been investing for the last 4 months in an index fund that ranges in value from $25 to $50 and is currently priced at $50.  Let’s say also that you have been putting away $150 per month.  Here’s how it would look:

Month             Price             Shares         Total Investment

Month 1          $25                 6                     $150

Month 2          $30                 5                     $150

Month 3          $40                 3.75                $150

Month 4          $50                 3                     $150

At the end of the 4 month period, you now have 17.75 shares for a total value of $887.50 even though you only invested $600.  Your average buying price comes out to $33.80.  What happened here in this little bit of financial voodoo is you took much of the market timing risk out of the fund and reduced your overall volatility.  If you had invested all your money in month 4, you would have made nothing.  Consequently, if you had invested all your money in month 1, you would have made quite a bit more.  The whole point of this type of investing is that you will most likely get a better return with less volatility and risk.

I mentioned before that you are probably already doing this without even knowing if you contribute to a 401(k) or another form of retirement account.  Usually, your employer takes out a certain amount of money you’ve elected from your pay check each pay period and deposits it into your selected funds.  If you get paid bi-weekly, your dollar cost averaging is even more fine-tuned.

Ultimately, the only real downside to using dollar cost averaging is if you have high transaction or brokerage fees.  If it costs you $7 for a trade, then investing $100 a month probably doesn’t make sense.  To mitigate this issue, I tend to use funds in which transaction fees are waived by my brokerage.

I sleep more sound at night when I use dollar cost averaging, but ultimately, you have to invest in the mode that makes you happy.

Wonderful Moment of the Day:  Hot showers on cold days.