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Saving and Investing: An Introduction to Dollar-Cost Averaging
Friday, 20th April 2007 (by J.D.)This article is about Basics, Money Hacks
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This is part fifteen in a series that will occupy the “money hacks” slot at Get Rich Slowly during April, which is National Financial Literacy Month.
The three videos scheduled for today were going to cover hedge funds. After watching them, however, I’ve decided they’re not necessary for basic financial literacy. Unless I’ve missed something, hedge funds are targeted primarily at institutional investors. If you want to learn more about them, you can visit the SEC or watch Michael’s videos at YouTube:
- Hedge funds 1: What is a hedge fund?
- Hedge funds 2: What is short-selling?
- Hedge funds 3: Different strategies
Instead of covering hedge funds, we’ll move on to Michael’s discussion of timing investments and dollar-cost averaging:
Timing investments and dollar-cost averaging (5:52)
Because the stock market has historically shown strong returns over long periods, we can take advantage of this by ignoring short-term market movement and making regularly scheduled investments, regardless the market’s condition. This technique is called “dollar-cost averaging”.
Critics of dollar-cost averaging argue that it provides a lower return than investing a lump sum now. This is true. If you have a choice, you should always invest early instead of waiting to spread the investments over time.
However, dollar-cost averaging is an excellent technique for those who cannot afford to invest a large sum at one time. If you have the choice between saving $4000 to put into your Roth IRA at the end of the year, for example, or paying $333.33 a month, do the latter. Don’t bother trying to time the market, but make regular scheduled investments.
(I’ll scan and post Michael’s chart later. I hadn’t intended to post this video today, and so I’m unprepared.)
Next week, Michael’s video series winds down as he describes how to put the concepts he’s taught us into practice.
Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. Look for more episodes of Saving and Investing at Get Rich Slowly every weekday during the month of April. For more information, visit Michael’s site, Saving and Investing, or purchase his book.
11 Responses to “Saving and Investing: An Introduction to Dollar-Cost Averaging”
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April 20th, 2007 at 12:12 pm
Note that if you are investing in something requiring a commission (individual stocks, ETFs, etc.) that the commissions will eat into some or most of the gains of dollar-cost averaging, since you’ll be paying that commission twelve times (in the above example) vs. once.
Of course, doing it monthly you are much more likely to actually CONTRIBUTE to your Roth or other investment than if you wait till the end of the year (likely you won’t have $5000 just sitting around…)
April 20th, 2007 at 1:11 pm
Even if you are contributing $5,000 into your IRA at the beginning of every year, you’re still dollar-cost-averaging… just on an annual basis.
April 20th, 2007 at 6:30 pm
I suggest dollar cost averaging to folks that I don’t think have what it takes to ride out a big drop. If there’s any chance that they’ll panic and sell their positions because of a sudden decline, then dollar cost average adds some psychological protection. It eliminates the possibility of having things decline the day after a large amount of cash is invested.
April 20th, 2007 at 6:51 pm
You missed one of the key advantages of dollar-cost averaging, from which the name is derived.
By definition, when you are doing a DCA, you invest the same amount each period. What this means in practice is that when your investment is at a lower value, you buy more shares, and when it is at a higher value, you buy fewer shares. As a result, your average price per share is lower than it might otherwise be.
April 21st, 2007 at 5:11 am
That is how I invest! How else does a person really invest money anyway. You get paid weekly, you invest weekly (or monthly). No matter what you call it, you’re still DCA.( I don’t know of a person that invest new money on a daily basis!)That isn’t what real life is about. I use DCA and have done pretty well with it in my ETF’s account.I invest money as soon as I get it, so I’m not tempted to spend it.Everybody is DCA”ing
April 21st, 2007 at 12:06 pm
(I am not a financial advisor and this is not professional advice)
The dollar cost averaging method is a good way for someone to invest when they cannot invest larger amounts all at one time, but it can also hurt in the long run. If you don’t have time to activly manage your investments and are willing to suffer some returns, then average cost is your way to go.
Average cost means half the time you are buying low and half the time you are buying high. The higher the price, the fewer shares you get. In reality, the price is usually way too high on the day you buy and lower the day before and day after, because they know everyone’s “automatic” pay deduction hits the fund or market on the same day.
What I do is a combination of these methods. I invest in an IRA that is invested in a mutual fund (a Fidelity fund, if you must know, and not all funds are equal, but I have experience a 28% return in the last 12 months).
The difference is, I can put my monthly $333.33 contribution into the cash account earning money market rates until I am ready to buy a large chunk of whatever I wish to buy.
But, you say money market rates pay nothing, and don’t earn anything in 12 months? Why put the money in something earning next to nothing?
Because, when my mutual fund pays dividends the price drops SIGNIFICANTLY, and my $4000 dollars buys more shares that gain in value.
An example of my fund had a price per share of $19.29 per share before dividends and capital gains were paid. After these were paid, the price dropped to $16.41 per share, but I gained an additional 30.15 shares (that one day, I actually lost .03/share in total price). That same stock has grown from $2,897.21 for 174.216 shares @ 16.63 per share on 6/21/06 to $3,711.29 for 204.355 shares @ 18.16 per share on 4/20/07, a gain of $814.07 (give or take .01) or 28.10%
I admit this is not typical results, but this is not typical investing. Average cost is “Buy average, sell high”…this is “Buy low, sell high”, which yeilds atypical results.
So what does all that mean? Well if I buy the average rate, I will buy 1/2 of my purchases between 16.21 and 19.35, and the other half the other way around. Most of the time, it will be at higher rates and fewer shares. Or, I hold the money in the cash money market account and wait until dividends are paid, then pounce. Or, if the my fund drops lower than the dividend rate during the year because of market conditions, buying shares at the low rate mean more shares.
In my case, dividends were paid on 12/8/06. If I had bought $4,000 of shares on 12/7/06 at $19.29 per share, I would have only received 207.361 shares of this fund. Sure, I would benefit from the split (if I caught it in time), but lost .03 per share. If I bought on 12/8/06 after dividends were paid and the price dropped to $16.41, that same $4,000 would buy 243.754 shares. By waiting until dividends are paid, I gain 36.393 shares of stock in this fund.
If you must contribute small amounts monthly, then put them in a cash account that earns interest and is immediately available for purchase of stocks, bonds, or mutual funds, and buy at the right time, not the average time.
Also, diversity is the key. This example is just one fund, and if I were to invest in only mutual funds, I would certainly have more than one.
April 21st, 2007 at 8:40 pm
First of all, this technique is why Zecco can be such a good deal. You get 40 free trades a month, so you can do up to 40 buys a month on a regular basis.
I tend to like another strategy though. I invest around the same amount per month, but I always try to keep the percentages of each of my holdings the same. For example, let’s say one month I have $1000 in stock A, $2000 in stock B, and $4000 in stock C. The next month, those same stocks are worth A:$1500, B:$2000, and C:$3500. If I was putting in $1000, I would put it all into B and C, since A has too much of the percentage now.
This avoids one of the major problems of DCA, which is that if you always put the same amount into each holding, you end up with a less diversified portfolio. For example, you might start out with 50% US stocks and %50 foreign stocks. After a few years of great US stock earnings and poor foreign performance, you might have 80% US stock and %20 foreign stocks. Now if the US market goes bad, the foreign stocks will have a hard chance making up for the losses on your US holdings.
April 21st, 2007 at 11:58 pm
Saving and Investing: An Introduction to Dollar-Cost Averaging…
A video introduction to dollar-cost averaging. Interestingly, Phil Town says that DCA doesn’t work in a flat or slowly-growing market. Hmmm….
April 24th, 2007 at 9:31 am
Dollar Cost Averaging is just a fancy term, used by people in the industry, to sound smart. It really means nothing.
The stock/fund price is what it is, I don’t care how/when you buy it. You can make money and you can loose money. Bottom Line.
December 18th, 2007 at 5:01 am
[...] Never forget that diversity reduces adversity. Don’t just buy stocks — buy stocks, bonds, and other investments classes. Within each category, diversify further. And don’t just buy one stock — buy mutual funds of many stocks. (Malkiel makes his case with the stark example of a 58-year-old Enron employee who had a $2.5 million 401k — of Enron stock. When Enron went bust, the employee not only lost her job, but her retirement savings vanished completely.) Finally, the author recommends “diversification over time” — making investments at regular intervals using dollar-cost averaging. [...]
January 25th, 2008 at 9:25 am
[...] Saving and Investing: An Introduction to Dollar-Cost Averaging [...]