The idea with dollar-cost averaging is relatively simple: You buy equal dollar amounts of the same investment on a predetermined schedule.
Please note the italics in that last sentence. Dollar-cost averaging IS NOT buying a fixed number of shares on a regular basis. In fact, it is quite the opposite. Here's why ...
Let's say you've decided to invest $10,000 in XYZ Corp. Rather than deploying the entire amount at one time, you might instead opt to purchase $1,000 of XYZ stock on the first day of each of the next 10 months.
What's the logic behind this approach? Well, you can expect just about any stock's price to vary substantially over a ten-month period. So, when the price is higher, your $1,000 will buy fewer shares; when the price dips, your $1,000 will buy more shares.
In other words, buying equal dollar amounts over time allows you to reduce your risk to a stock's short-term price movements, automatically encouraging you to buy more when prices are lower and less when prices are higher.
It also removes much of the emotion from the investing process. You've already committed to buying the stock at regular intervals, regardless of market conditions.
And because you're doing this automatically, it doesn't require more than a few minutes of your time (if any at all!).
Okay, But Surely Dollar-Cost Averaging
Wouldn't Have Worked in the Last Year, Right?
When I wrote that original Money and Markets piece on dollar-cost averaging back on June 17, 2008 ... the S&P 500 was sitting at 1,400. Now, it's more like 1,000. And I don't have to tell you just how low it went in between.
So clearly someone who started dollar-cost averaging on the day of my column lost out, right?
WRONG.
In fact, as you'll soon see, an investor who began using dollar-cost averaging in June 2008 has actually come out better than someone who regularly put their funds into a money market account over the same time period!
Let me give you the math behind that bold claim ...
Frankly, it really doesn't make much of a difference whether we pick a daily, weekly, or monthly approach. But for simplicity's sake, let's stick with monthly.
We will assume that our hypothetical investor chose to buy a very common index exchange-traded fund such as the S&P 500 SPDR (SPY). As you probably know, that popular ETF attempts to match the broad performance of its namesake U.S. stock index.
And while I could certainly assume that our investor bought on the 17th of every month (the day my original column was published) I'm going to just use the first trading day of each month.
Lest you think I'm trying to avoid including June 2008, I simply pretended that the day of my column counted as the buy date for that month.
I figured our investor would put in $1,000 every time.
So, here's what the purchases looked like ...
| A Recent Dollar-Cost Averaging Case Study ... | |||
| Date | SPY Price | Shares Purchased | $ Invested |
| | 124.62 | 8.02439 | $1,000 |
| | 123.5 | 8.09717 | $1,000 |
| | 125.41 | 7.97385 | $1,000 |
| | 113.6 | 8.80282 | $1,000 |
| | 94.83 | 10.54519 | $1,000 |
| | 88.23 | 11.33401 | $1,000 |
| | 89.1 | 11.22334 | $1,000 |
| | 81.78 | 12.22793 | $1,000 |
| | 72.99 | 13.70051 | $1,000 |
| | 79.07 | 12.64702 | $1,000 |
| | 86.93 | 11.50351 | $1,000 |
| | 92.01 | 10.86838 | $1,000 |
| | 91.95 | 10.87548 | $1,000 |
| | 98.81 | 10.12043 | $1,000 |
| | 101.2 | 9.88142 | $1,000 |
| TOTALS = | | 157.82545 | $15,000 |
| Today's Value | 101.2 | X 157.82545 | $15,971.94 |
| Profit = | | | $971.94 |
As you can see, our hypothetical investor's $1,000 bought far more shares of the SPY during the market's decline and far fewer shares when prices were higher.
The end result of all that buying is that our investor is sitting on 157.82545 shares of SPY today. And based on a recent price of 101.2, that means the total holdings are worth $15,971.94.
Remember, we're talking about a 15-month period. So that means a total of $15,000 was invested.
End result: Our hypothetical investor is up $971.94, a return of 6.48 percent on the original $15,000 investment.
Yet over the same timeframe, the underlying investment — the S&P 500 index — is DOWN about 28 percent!
Amazing, isn't it?
Meanwhile, had our investor played it "safe" and just put $1,000 into a money market fund every month ... the overall return would have probably been less than 1 percent given current rates.
As you can see, dollar-cost averaging is truly a powerful way to "cut through the market chop" and steer your portfolio through major storms.
But, I want to point a couple things out ...
Final Words on Dollar-Cost Averaging,
And Investment Strategies in General ...
First, dollar-cost averaging is clearly not right for every investor. It requires a steady stream of investment money and could entail regular brokerage commissions. That makes it ideal for a regular company retirement account such as a 401(k) plan.
But please note that it is the same principle at work when you reinvest dividends. And I'd also say it's a great way for an investor to gradually invest a large lump sum, such as an inheritance.
Of course, the more important thing to note is that dollar-cost averaging takes guts. How many people — having invested thousands of dollars when the S&P 500 was at 1,300 and 1,400 — would have still been able to put more money in at 700?
In most cases, that is precisely the point at which the majority of investors would switch their investment allocation to something else!
My point? Human nature is perhaps the biggest threat to your wealth.
I don't care if it's dollar-cost averaging into an index fund ... trading commodities ... or buying and selling real estate. As long as you do your homework and pursue a time-tested investment strategy — consistently and without fail — I believe you will come out ahead in the long run.
Best wishes,
Nilus
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