Simple Investing Strategies: Dollar Cost Averaging

Saving & Investing / Monday, October 31st, 2011
Dollar Cost Averaging is a simple, but powerful, investing technique.

Even people who aren’t into the stock market know that first rule of investing is “buy low and sell high.”

Unfortunately, another common piece of investing advice is “don’t try to time the market.”

Well if you don’t try to time the market, how in the world are you supposed to buy low and sell high?

Luckily there’s a tried and true way to help you with the ‘buy low’ part and you’re probably already doing it. It’s called Dollar Cost Averaging.

What is Dollar Cost Averaging?

“Dollar Cost Averaging” is a boring and complicated name for something that is really simple and exciting.  (Well, at least I think it’s exciting, but either way it’s definitely simple.)

Consider this:

You have $500 to invest and you want to put it in a certain mutual fund. For simplicity’s sake, let’s say the mutual fund is selling for $100/share. If you dump your $500 investment in at one time, you get five shares.

Easy peasy.

But let’s say that instead of dumping your whole $500 in at one time, you decide to spread it out over five months and invest $100/month. Now obviously, the cost of the mutual fund will fluctuate over those five months and your $100 investment will buy you more or less in the way of shares, depending on the price.

For the sake of this example, let’s say your investments looked like this:

  • The first month the mutual fund is selling for $100/share so your $100 investment buys you one share.
  • The next month the price of the mutual fund rises to $115 and your $100 only buys you .87 of a share.
  • The third month the price rises again to $125/share and your $100 now only buys you .80 of a share.
  • Now assume that the next month the share price takes a tumble and your mutual fund is now selling at $90/share. Your $100 buys you 1.11 shares.
  • And in the final month the price goes back up to where you started at $100/share and your $100 again buys you one share.

If you look at the bolded numbers above you will see that when you invest a single amount at certain intervals — in this case monthly — you automatically buy more shares when the price is low and fewer shares when the price is high.

That is what Dollar Cost Averaging is all about.

And the best part is that there’s no timing of the market required on your part (which is a good thing because that’s difficult/impossible for even the most educated among us.)

And that’s what I find exciting: that something so simple can be so effective!

Why You Are Probably Already Dollar Cost Averaging

Earlier I mentioned that you are probably already taking advantage of Dollar Cost Averaging and may not even be aware of it. That’s because for most of us, our income comes in monthly (or in other regular intervals) and so that is how we invest.

Consider that 401k contributions are usually tied to an employee’s pay periods and so Dollar Cost Averaging happens naturally.

But what if your investing isn’t tied to pay cycles?

In that case you need to understand dollar cost averaging and embrace what it can do for you.

  • Got a tax refund you want to invest? Don’t dump it in all at once, Dollar Cost Average it.
  • Did Grandma and Grandpa give your new little addition a contribution for the college fund? Don’t dump it in all at once, Dollar Cost Average it.
  • Did you get a bonus at work that you want to invest? Don’t dump it in all at once…I think you get the idea.

I missed a golden opportunity to dollar cost average when I did my first dividend investing a couple of months ago.

I was so excited about having made a decision about what to do with my old 401k money that I picked a day when the market was down and I dumped the $5000 all in at once.

I know, I know. I would have been so much better off to Dollar Cost Average the investment over a series of months.

Heck, the market was on such a plunge that day, that I would have been better off to dollar cost average it hour by hour even. (I kid.) (Kind of.)

So how about you? Have you had an opportunity to use Dollar Cost Averaging? Were you using it without realizing it? Wish I’d get back to blogging about coupons? Weigh in!

Note: I am not a financial professional. You should consult your own financial adviser for advice on your particular situation. But when you do, be sure to ask about Dollar Cost Averaging!

This post is part of Frugal Fridays at Life As Mom.

3 Replies to “Simple Investing Strategies: Dollar Cost Averaging”

  1. I dollar cost average through my 401k at work, and I sort of do through my Roth at Zecco. I say sort of because I usually invest every month, just not on a set day. And lately I haven’t sent anything in, but only because I’m trying to put as much as possible toward getting our mortgage paid off.

  2. Jackie, I would consider investing every month — no matter the day — to be dollar cost averaging. My oh, so sophisticated method is to invest every month and to pick a day when the markets are down. That’s as much timing the market as I try to do.

    Congrats on working on your mortgage pay-off. How great will that feel?

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