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).
Periodic investment plans do not assure a profit and do not protect against loss in declining markets. Dollar cost averaging is a strategy that involves continuous investment in securities regardless of fluctuating price levels of such securities, and the investor should consider their financial ability to continue purchasing through periods of low price levels.
|Dollar Cost Averaging|
|The chart compares making a single investment of $12,000 in stocks with a program of adding $100 monthly to an investment in stocks while leaving the balance in a money market account. (CS000138)|
Sources: Standard & Poor's; Barclays Capital. Stocks are represented by the S&P 500 index, an unmanaged index generally considered representative of the U.S. equity market. Money market account is represented by the Barclays 3-Month Treasury Bills index. Index returns assume reinvestment of income and capital gains and do not reflect investment fees or expenses. Past performance does not guarantee future results. You cannot invest directly in any index.
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. Consider the accompanying chart, which shows the result of investing $50 in stocks every month for 12 consecutive months.1
|The Benefits of DCA|
|Month||Share Price||Shares Bought|
|AVERAGE PRICE PER SHARE:||$14.25|
|AVERAGE COST PER SHARE:||$14.05|
Another potential benefit of using DCA is that it ensures that your money purchases more shares when prices are low and fewer when prices are high. Over the long term, the result could be that the average cost you pay for the shares may be less than the average price. Assume you invest $50 per month in an investment for 12 months and every month the share price fluctuates a bit. You can see that your $600 total would have bought you 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 a lot of money.
In addition, DCA can offer the psychological comfort of easing into the market gradually instead of plunging 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.
And last, DCA may help you make savvy investment decisions if you stick with it. For 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.
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.2
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 in more recent years. 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 there's a sustained market decline, two years thereafter you might discover that your $300,000 life savings would be worth only $200,000. Over time you might recover your investment, but you have to weigh the consequences of loss before choosing lump sum vs. 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 potentially lower your average cost per share, and allow you to feel more comfortable during uncertain markets knowing that you made sound investment decisions. Keep in mind, however, that you should consider your ability to purchase over long periods of time and your willingness to purchase through periods of low price levels.
1Source: Standard & Poor's. Stocks are represented by the S&P 500 index.
2Source: Richard E. Williams and Peter W. Bacon, "Lump Sum Beats Dollar Cost Averaging," Journal of Financial Planning, April 1993, pp. 64-67.
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