Dollar Cost Average

What is dollar cost averaging?

When you dollar cost average, you place the same quantity of money into an investment regularly and consistently. For example, I practice dollar cost averaging by investing the same amount of money into my retirement account on the 15th and 30th's of each month.

What are the advantages?

The main reason is that you will end up buying less of your investment when it is high and more of it when it is low. As a result your overall cost to buy the investment over time is lower than if you purchased the same quantity of shares each time. This is why it is called dollar cost averaging - it lowers your overall per share cost.

For example, lets say you buy $50 from a mutual fund every month. The shares you buy cost $10 the first month, $15 the second month, and $5 the third month. Is your average cost $10? Nope. Lets calculate it. The first month you buy 5 shares, then 3.33 shares the second month, and 10 shares the 3rd month. Therefore, you have bought 18.33 shares for $150 dollars and have payed $8.18 per share.

It also protects you against wild market swings. For example, if the current market prices are high, you don't want to invest all your money at that time because you'd have paid a high price. However, you want to get started because it might still go higher. So, you practice dollar cost averaging. Next month the market drops like a stone. No problem, now you're going to buy on the cheap. Or, if the price shoots up even higher, its OK because you got some shares at the lower price.

Dollar cost averaging not only protect you against market swings, but it allows you to benefit from them. Lets say you're going to invest $100 per month. Volatility, instead of steady increases, can actually help you. In the below graph, there are two examples. In the example on the left, there's volatility. It goes up, it goes down, it goes all around. It starts and ends at $10. The example on the right starts at $10 and slowly goes up. Despite having a lower ending value, you ended up with more money in the example on the left. If this doesn't convince you to keep investing regularly (or even put more money in) when the markets are down, I don't know what will.

How do I practice dollar cost averaging?

It depends on who you're investing with. 401k plans automatically do it. You can set up many mutual funds to do it. I do it with Vanguard for my Roth IRA. It was easy to setup.

It is harder to do with a regular stock brokerage. Not all of them will purchase partial shares - which you need to be able to do to practice dollar cost averaging. Not only is it more difficult to practice dollar cost averaging with a stock broker, but, unlike 401k plans and (many) mutual funds, you pay a brokerage fee every time you buy. The fee can really eat at your profits. If you pay a $10 fee on a $100 investment, you've already lost 10% of your investment and have to make 11% on your money just to break even!

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