Friday, October 3, 2008

Dollar Cost Averaging – A Primer

Learning how to invest often seems like a daunting and frightening process, and all too frequently financial professionals use a language of their own to potentially confuse, rather than educate, their clients. Many financial professionals feel their livelihood may be threatened if the larger society understands the principles to building wealth. Other advisors might fear that their client will not find value in the relationship, if the investment professional is telling the client what the client already knows. Such beliefs have been a bane to individual investors and the industry as a whole for decades, but there is a way to combat the confusion that comes with being in unfamiliar territory. It is simple. You learn the language. For example, understanding the concept of dollar-cost averaging is one of many strategies that can help you make sense of investment advice and judge the quality of the recommendations received.

As most people know, investment markets tend to trend higher over extended periods of time. Many forget that picking the tops and bottoms is everything but it is impossible - even for the most seasoned of market timers. Let us say that again, Market timing is everything but it is not possible. Moreover, we may enter periods where investments decline for years at a time. While most know these facts, the fear associated with potential declines keeps many people from ever entering the realm of investing. There is, however, a solution and many of us use it each time we make a deposit to our 401k or 403b retirement plan.
Whether you call it that or not, dollar cost averaging is an investment discipline in which investors commit a specific amount of money to their portfolios at designated intervals, say monthly. This helps to mitigate volatility and ensures that investors purchase more of the underlying securities when the price is low, and less of the security when the price is high. Buying low and selling high is the key to investment success and this strategy helps take care of the buying half. Moreover, once you start, you don’t have to think about it other than to rebalance to keep your investments diversified.

As an example, let’s say you invest $50/month into a mutual fund. If the fund is trading at $50 a share in the first month, you will buy 1 share of the fund. If the share price takes a precipitous decline the second month and is now trading at $25/share, the same $50 will purchase 2 shares the second month. You now own 3 shares at an average price of $33.33/share and you have bought twice as many shares at $25 as you did at $50. In other words, you are ensuring the purchase of more shares at lower prices.

Let’s say in the third month the price is again $50. Had you put $150, as a lump-sum, in the market the first month and not dollar-cost averaged, you would have purchased 3 shares and they would be worth what you paid for them, $50, a 0% return. On the other hand, had you dollar cost averaged at $50 per month for the three months, you would own 4 shares, worth $200 for a 33% return on your invested assets or $150. You see, as long as a lower price exists prior to the final price, you will have more shares purchased at the lower price to enhance your return. There you have it, Financial Success in a nutshell called Dollar Cost Averaging.

Heath Lauseng[i] and
Robert O. Weagley, Ph.D. CFP®
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211

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