Investing Articles |
Pay Yourself First — And Regularly — Through Dollar Cost Averaging (DCA)
To remain financially responsible, everyone must pay bills on a regular basis. These bills include mortgages, utilities, car loans, and credit cards. Unfortunately, many people do not also heed the oft-quoted advice to pay themselves first.
The harsh reality these people may discover is that a steady saving and investing plan is sometimes necessary to help pursue such financial goals as paying for a wedding or new car, buying a house, and funding retirement. Financial experts disagree on the ideal way to invest in order to meet such goals, but one strategy can help you develop a systematic investing plan, while potentially saving you money and easing your mind along the way. It’s called dollar cost averaging (DCA). Dollar cost averaging does not assure a profit nor does it protect against a loss in a declining market. This plan involves continuous investment regardless of fluctuation in price levels. You should consider your financial ability to continue purchasing through periods of low price levels.
DCA Defined: A System For Regular Investment
Dollar cost averaging is a technique often used in buying mutual funds in which investments of defined amounts are made on a regular basis. As a long-term, disciplined strategy, DCA can help you take advantage of the benefits of compounding to potentially build a sizable sum.A List Of Long-Term Benefits
Through The Years, DCA Can Provide An Overall Lower Share Price And More Shares.
DCA ensures that your money purchases more shares when prices are low and fewer when prices are high. Over the long term, the result may likely be that the average cost you pay for the shares will be less than the average price.
Example. Assume you invest $50 per month in a mutual fund for 12 months and every month the share price fluctuates a bit. Now assume that your $600 total bought you a total of 42.7 shares. The average price per share, as calculated by adding up the monthly prices and dividing by 12, would have been $14.25. However, the average cost that you would have actually paid, as calculated by dividing the total amount invested by the number of shares, would have been $14.05 per share. Over the years, this method could potentially save you money.
DCA Can Ease You Into Yhe Market, Rather Than Plunging You In All At Once.
Although DCA does not assure a profit or protect against a loss in declining markets, its systematic investing "habit" helps encourage a long-term perspective, which can be soothing for people who might otherwise avoid the short-term volatility of the riskier, but potentially more profitable, investments such as equities.
Helps To Equalize Gains And Losses
DCA may also help you make savvy investment decisions if you stick with it.
Example. If your investment rises by 10%, you will likely post big gains because of the shares you’ve accrued over time. And if it declines by the same amount, take comfort in knowing that your next investment will purchase more shares at a less expensive price
—
shares that may regain their value and even exceed the higher price in the future.|
| ||||
|---|---|---|---|---|
|
Month |
Share Price |
Shares Bought | ||
|
Jan |
$15 |
3.3 | ||
|
Feb |
$13 |
3.8 | ||
|
Mar |
$12 |
4.2 | ||
|
Apr |
$14 |
3.6 | ||
|
May |
$13 |
3.8 | ||
|
Jun |
$12 |
4.2 | ||
|
Jul |
$13 |
3.8 | ||
|
Aug |
$14 |
3.6 | ||
|
Sept |
$16 |
3.3 | ||
|
Oct |
$16 |
3.1 | ||
|
Nov |
$17 |
2.9 | ||
|
Dec |
$16 |
3.1 | ||
|
TOTAL SHARES: |
42.7 | |||
|
AVERAGE PRICE PER SHARE: |
$14.25 | |||
|
AVERAGE COST PER SHARE: |
$14.05 | |||
 |
|
| ||
|
|
| ||
|
|
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Assess Its Limitations Judiciously: Lump Sum Vs. Systematic Investing
Although investing a regular amount each month may be a sound way to develop a regular investing habit, some experts say that it may not be the best way to manage a financial windfall, such as an inheritance, a bonus, or even lottery winnings.
A landmark study by Peter Bacon and Richard Williams, professors at Wright State University, suggested that investing such a lump sum all at once as soon as it is received reaps greater financial rewards than DCA, albeit at a higher level of risk.
The study tracked lump sum vs. systematic investments over 780 different 12-month periods from 1926 through 1991. Results indicated that an investor would have fared better 64.5% of the time by investing his or her money in a lump sum. This implies that if you have a large sum of money earmarked for the stock market, it should be put to work as soon as possible. Though past performance does not guarantee future results, stocks have historically risen the most over time.
Remember, however, that markets change over time, and this study may have yielded different results if a different time period were examined. And, while you evaluate the relevance of the study to your investing needs, also consider the following situation: If you’re 65 years old and you receive a $300,000 401(k) distribution, can you afford to take a chance that the market will drop shortly after you invest your retirement proceeds? If a situation similar to the market decline of the last several years develops, two years thereafter you might discover that your $300,000 life savings would be worth only $200,000! While chances are good that this wouldn’t happen to you, and over time you could expect to recover your investment, you have to weigh the consequences of loss before choosing lump sum vs. DCA.
A Long-Term Strategy To Consider: Regular Investing Through DCA
While
investing a lump sum at the most opportune time can potentially profit
you more than if you dollar cost average your investment, defining
"opportune" is difficult for even the most seasoned experts. As a
long-term strategy, you may find DCA to be more appropriate to help
increase return potential, potentially lower your average cost per
share, and allow you to feel more comfortable during uncertain markets
knowing that you make sound investment decisions. Keep in mind that the
DCA strategy involves continued investment. You should consider your
ability to continue purchasing through periods of low price levels.
Points To Remember
- As a long-term method of making systematic investments of regular amounts, dollar cost averaging (DCA) can help build on returns, lower your average cost per share, and help soothe your concerns about uncertain markets.
- DCA is a technique often used when purchasing mutual funds; over time, compounded assets may potentially amount to a sizable sum.
- Because you purchase more shares when prices are low and fewer when prices are high, DCA may help you lower your average cost per share over time.
- DCA allows the psychological cushion of knowing that investments are made gradually.
- DCA does not assure a profit or protect against a loss in declining markets.
- It can also help you make potentially savvy investment decisions such as value-oriented purchases.
- One study done by university professors found that making lump-sum investments was a more profitable way of managing large sums of money than DCA.
- While investing a large sum of money at the opportune time can be more profitable, defining "opportune" can be difficult even for experts.
