Today we are going to discuss dollar cost averaging (DCA) and how it is most likely helping your retirement portfolio.
“Dollar Cost Averaging- The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.” 1.
Dollar Cost Averaging for Dummies
So to put it more simply, dollar cost averaging is when you are investing in a type of investment that has shares (stocks or mutual funds) and you are putting in new money on a consistent basis. You are investing the same amount of money each time, but buying a different amount of shares, due to the fluctuation of share price of a stock or mutual fund.
The Benefit of Dollar Cost Averaging
As it works out over time, because you are able to buy more shares in lower prices, the average price you pay is always lower than the average price of the stock/mutual fund. It is hard to wrap my mind around it, but whether the price is going up, down or both, you will get your stocks at a discount using Dollar Cost Averaging.
Here is a very basic example. If you put in $100 a month to a mutual fund priced at $10 per share the first month you would buy 10 shares for that price. Let’s say the price goes up to $20 per share the second month, so your $100 would buy 5 shares. So with dollar cost averaging you would have 15 shares after 2 months. At the same average share price of $15, if you invested the same $200 you would only have 13.3 shares.
So most individual investors saving for retirement use DCA as they invest a monthly amount into their retirement account. This makes sense and is obviously a good way to invest. Much better than to try and time the market and only put money in when you feel the market is safe or poised to have a big run up. It is also a way to put investing for retirement on the monthly budget and plan it in instead of having to make room for it.
Is Dollar Cost Averaging ever bad?
There is only one situation in which Dollar Cost Averaging is not the best option. If you have a lump sum from receiving an inheritance, bonus, or are just starting to invest, it is almost always best to invest the lump sum rather than putting it in slowly over time. Let me explain.
Throughout history the market has ALWAYS gone up over the long term, meaning 10, 20, 30 years. There has never been a 20 year period where there has been a loss in the market. So the more shares you can buy now, usually the better you are. If you wait to invest, odds are you are going to be buying at a higher price then you could have earlier. Going back 88 years, 66 of those years have been up markets. Going forward there is no way for us to know when the market will be up or down.
So the main reason people would rather use Dollar Cost Averaging over contributing a Lump Sum is FEAR. They are scared the market will crash or take a big drop, because that is what they say on the news almost every single day. They have been saying it ever since the market bounced back in 2009. We should not let fear control our investment decisions.
For the average investor saving for retirement, consistent monthly contributions are the way to go, but if you ever do come across a lump sum of money that you want to invest, don’t wait to invest it.
By Jimmy Hancock
References
1. Investopedia. “Dollar-Cost Averaging (DCA) Definition | Investopedia.” Investopedia. Investopedia US, n.d. Web. 04 Sept. 2014. <http://www.investopedia.com/terms/d/dollarcostaveraging.asp>.
2. Miller, Steve. “Dollar Cost Averaging EP 265 08192014.” Livestream. Matson Money, 19 Aug. 2014. Web. 04 Sept. 2014. <http://www.livestream.com/markmatson/video?clipId=pla_0a3928e4-319d-4575-9297-eac738bffcd7&utm_source=lslibrary&utm_medium=ui-thumb>.