The Value of Dollar Cost Averaging
If you are currently contributing a part of your earnings to a qualified retirement plan, such as a 401(k) plan, you are already applying the dollar-cost averaging strategy. Fundamental to the strategy is a commitment to investing a fixed amount at a fixed time- whether it’s $50 or $500 each month of every-other-month for example. Each month, your fixed amount will buy a certain amount at the then current prices. As prices decline, your fixed amount will be able to buy a higher number; when prices increase, less is purchased. If the overall trend for stock prices is up, as it has been since the inception of the stock market, your average purchase price, or cost-basis, will always be less than the prevailing share price. Of course, it would be important to follow this strategy through at least a few market cycles (up and down markets) to realize the full value of dollar-cost averaging. You can, however, get a sense of how dollar-cost averaging will work in your favor in just a few short months.
Let’s say you decided to start investing after the stock market has reached new highs. If you start to invest $500 a month in a stock index fund priced at $20 a share, your initial investment will purchase 25 shares. If the stock index immediately declines in value to $15 a share, your next monthly investment would buy 33 shares. You will then own 58 shares with an average cost-basis of $17.17 per share. If the stock index climbs to new highs the next month, and the share price reaches $30 a share, you will add 16 shares for a total of 74 shares, and your average share price will be $20.27, almost $10 below the current share price.
Another value of dollar-cost averaging is that you don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market. As long as the stock market continues with its historical, upward trend, with periodic declines, the value of your portfolio will be higher than your average cost-basis.
The key to its success is your ability to commit to a systematic process of setting aside a fixed dollar amount (that can be increased as your cash flow allows), and following a disciplined investment strategy that includes broad diversification across several stock market segments.