Investing: Dollar Cost Averaging

Happy New Week!

Many people often ask me if I have any stock tips. Usually, they hope for some kind of inside information, as if I had a clue! My basic recommendation is that if you have less than $100,000 liquid, investible cash, don't worry about buying ANY individual stocks. Stick to a mutual fund with an above-average management team. The cost benefits and professional management outweigh the risk involved in trying to make a killing on an inside tip. We will talk about Mutual Funds in more detail in another post, but today I want to talk about a way to maximize returns through systematic investing. We are talking about Dollar Cost Averaging.

Dollar Cost Averaging (DCA) simply means that we will invest a fixed amount of money, on a regular basis, without regard to market conditions. In an unpredictable market, DCA helps to minimize market swings, removes some of the investment risk, and allows for continuous market investment, regardless of market conditions.

Two methods of Dollar Cost Averaging are prominent. Lump Sum Allocation and Regular Contributions.

If you have a lump sum of money to invest, whether from an inheritance, lawsuit proceeds, or transfer from another investment (i.e. house sale), it is probably not a good idea to just throw all of this money into the market at once. If you pick a day that the market has peaked, you could see your investment diminish quickly in the short-term. Of course, you might get lucky, and pick the low point of the market, but I've never been that lucky.

With a Lump Sum, you would place the money into an investment account, but you would allocate that money for investment over a period of time. Let's say you wanted to allocate over one year. You would place the bulk of the money into a low-risk fund (i.e. Money Market, Bond Fund), and allocate the rest of it to your other investments (i.e. Diversified Mutual Fund). Each month, or even weekly if allowed, you would transfer a portion (e.g. 1/12, 1/52, etc.) from the low-risk investment to the diversified portfolio. A regular contribution would mean that you are investing money on a fixed schedule, such as weekly or monthly.

The goal of either method is simple. Each time you transfer or make an investment, you buy the maximum number of shares or investment units that you can for the amount invested. This ensures that you buy less shares when the price is high, and more shares when the price is low. Let's break this down with an example. Let's assume that you invest $200 per month for six months as follows:

As you can see, the average share price during the year was $11.72, however your average cost per share is only $10.98. Now, it doesn't always work this way, but more often than not, you will have a lower average cost per share, just by virtue of buying less shares at a high price and more shares at a low price.

This can be illustrated in other ways as well. Let's say that you own 2,000 shares of an issue that is worth $20 per share on January 1. That is $40,000 in your portfolio. If the market drops to $12.50 per share on February 15, you have lost almost 40% of your holdings in one fell swoop. Your first instinct would probably be to sell. That is almost always the wrong choice. You would just lock-in your loss at that point.

If you have faith in the company, your better decision would be to continue buying shares on the way back up. If you had been investing $500 per month previously, you should continue to invest the same amount. If you bought 40 shares at $12.50 the first month, and then continued to buy each month, you would be back to even, on a price-per-share basis, much earlier than if you just let your investment sit, and waited for the market. By the time the market fully recovered to $20 per share, you would be showing a gain, due to the many shares that you purchased when the price was down.

The nicest feature of Dollar Cost Averaging is the fact that you never have to worry about trying to time the market. Many people sit on the sidelines waiting for a price to fall, only to miss the opportunity to ride the price up. With Dollar Cost Averaging, you invest systematically, and you buy more shares at lower prices, which will make your average price per share lower.

I welcome your questions and comments. Invest regularly and wisely. Good luck!