Dollar cost averaging is one of the best secrets in being a successful long term investor. It’s simple, it’s quick, and it is mathematically genius. Dollar cost averaging makes sense and works for investors who want long term stock and mutual fund appreciation.
Dollar cost averaging is a systematic, ongoing deposit of a specific amount of money at a specific time for a specific investment. For example, contributing $200 on the 1st of every month to the XYZ mutual fund of America is dollar cost averaging. The contribution is made in the same amount, on schedule, and regardless of market conditions. In this sense, the investor is in no way trying to “time the market” or try to recognize low points in the market to buy in. On the contrary, the fund is purchased at whatever market price the fund is on the date of the scheduled buy. Month after month, regardless of price, the same set dollar amount is spent to purchase shares of the mutual fund.
The beauty of dollar cost averaging is that when shares are expensive, you buy fewer of them, and when shares costs less, you buy more. Over time, the costs of your various purchases and the number of shares you own average into what you hope will be a lower cost for more shares, than had you tried to time the market and buy at only the low points.
As an example, say you had $10,000 to invest in XYZ mutual fund. Suppose you made one lump sum investment when XYZ which was trading at $50 per share at that time. Ignoring fees associated with the purchase of the fund, you would own 200 shares at an average price of $50 per share. But, suppose instead that you split that investment into two lump sums of $5,000 each. You then purchased $5,000 of XYZ at $50 per share and another $5,000 of XYZ at $45 per share. As with the previous example, you still invested $10,000 into the fund. But, now you have 211 shares at an average cost of $47.50. You have more shares at a lower cost.
Though the above example is greatly simplified, with dollar cost averaging, this type of scenario is multiplied over years and years of investing to create a true average. A retirement plan at work is a great example of dollar cost averaging that you might already be using and putting this theory to your advantage. You can do the same with individual stocks you own by participating in the company’s dividend reinvestment program (DRIP) if offered.
This is the second weekly featured post on Own The Dollar from Sara Peak, a Certified Financial Planner and a veteran of the finance industry. In addition to her monthly “Money Matters” column in Kentucky Living magazine, she also writes about money and personal finance topics on her blog.