Dollar cost averaging: The "steady as you grow" strategy
Dollar cost averaging: The "steady as you grow" strategyFor many investors, dollar cost averaging may be one of the simplest ways to accumulate savings over time. Instead of buying the same number of units/shares each period, dollar cost averaging involves buying the same dollar amount of units/shares in an investment at regular intervals.
With this investment strategy, when the unit/share price is up, your dollar buys fewer units/shares, but when the unit/share price is down, your dollar buys more units/shares.
The dollar amount you invest on a regular basis is always constant, making dollar cost averaging a convenient and easy way to budget for the future. And because investments are made independently of market conditions, it's an effective way to take the emotion and the temptation to time the market out of investing.
The following charts demonstrate the potential benefit of buying a fixed dollar amount at regular periods (dollar cost averaging) over buying a fixed number of units or shares.
Both investors invested the same total dollar amount ($800) over the same period of time. Investor A paid an average of $8.00 for each unit/share, while Investor B paid an average of $7.74 and acquired more units/shares. Using the April 15 price of $8 per unit/share, Investor B's ending market value was $826.64 ($8 x 103.33 units/shares) and Investor A's ending market value was $800 ($8 x 100 units/shares).
But how would a lump sum investment (i.e., using the entire $800 to buy shares) on January 15 compare with either of the scenarios outlined in the charts above?
If Investor A and Investor B had each invested their entire $800 on January 15 (when the price per unit/share was $10), their lump sum investment would have bought each of them a total of 80 units/shares ($800 ÷ $10) for an ending value on April 15 of $640 ($8 x 80 units/shares). In this example, with a lump sum investment, both investors would have lost money.
However, in certain market scenarios, lump sum investments may yield better returns than dollar cost averaging, while in others it yields poorer returns. The chart below provides an overview of the relative performance of dollar cost averaging against lump sum investing in a declining market and a rising market.
*Market value on April 15 for the lump sum investment in each of the examples:
$800 ÷ price per unit/share on the date the lump sum was invested x price per unit/share on April 15.
In these examples, the lump sum investor has a higher ending market value if the investment is made towards the end of the period in a declining market. Similarly, in this example, the lump sum investor has a higher ending market value if the investment is made at or near the beginning of the period in a rising market.
Of course, it’s impossible to know whether the market will rise or decline over a given period of time. Market timing is the strategy of trying to predict future price movements, and is really more of a gamble than a legitimate investment strategy. And by trying to “time” the market, you may actually miss out on its best days. Your employer-sponsored group retirement plan may make investing regularly easy, through automatic payroll deductions.
While dollar cost averaging won't eliminate market risk or guarantee a profit, it's an investment strategy that makes sense for the patient, long-term investor concerned with managing price risk.
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Last Update: October 2005