How to Use Dollar Cost Averaging in Investing
The best way to make a fortune in the stock market is to buy low and sell high. In market parlance, that’s called “timing.”
But many individuals complain that they get their clocks cleaned when they try to time the market.
“The money other people make in the stock market comes directly out of my pocket,” groused one such investor. “I always buy high and sell low.”
Consequently, industry experts suggest that individuals forgo the urge to “time” the market and opt for a simpler, and often more effective, stock market strategy called “dollar cost averaging.”
The title sounds intimidating, but, in reality, investing doesn’t get any simpler than this. This is investing by automatic pilot--the equivalent of contributing to an automatic savings plan at work.
You simply decide how much you can invest each month (or each quarter), what you want to invest in, and, as the Nike shoe commercials say, “just do it.”
That’s it. You often can have your investment automatically deducted from your paycheck or bank account so you don’t even have to write the check. And you can, of course, stop funneling money into such plans at any time.
The mindlessness of this strategy does two things. It helps the undisciplined save by taking the function out of their hands. And it can help investment returns by smoothing out the rough edges in the stock market.
There are two caveats. First, this is a long-term strategy. It may work for those who invest for only a year or two, but it is best suited to individuals who stick with a particular investment for five years or more.
Secondly, it is predicated on the assumption that over a long period of time, stock prices will rise. History says that is so. If it is not, dollar cost averaging--and virtually every other stock market strategy except short selling--will fail.
Assuming you think that stock prices will rise over the long haul, there’s a compelling reason to consider this strategy. Namely, it works regardless of whether the market is going up, going down or just jumping around over the short term.
The best way to explain why is to look at some examples.
Let’s say someone invests $300 a month for five months in a rising market. In month one, that $300 buys 60 shares at an average price of $5 per share. The next month, the same amount buys only 30 shares because prices rise to $10. The average share price jumps to $15 in the third and fourth months, so this individual gets another 40 shares. If average prices jump to $25 per share, this investor’s $300 buys only 12 shares in the fifth month.
In the end, the investor has 142 shares, which cost a total of $1,500, or $10.56 per share. If sold that day, this investor would get $3,500 for those shares, taking home a $2,050 profit. If they continue to invest and the market continues to rise, the profits only increase.
The example works in reverse during a declining market. If the investor sold at the bottom, when the average price was $5, clearly he’d show a loss. But his loss is roughly $5.50 per share, versus $20 per share for the person who bought only at the top of the market and sold at the bottom.
Additionally, since the strategy is predicated on hanging in for long-term appreciation, market declines should just give the investor the opportunity to accumulate a large number of shares cheaply.
In essence, it’s what the professionals do. You’re buying a lot when prices are low. And you’re buying a little when prices are high.
Theoretically, you can use this technique to invest in virtually anything. But the strategy is most effective when investing in mutual funds that invest in the stock market.
That’s because dollar cost averaging thrives on volatility and relatively modest regular investments. Volatility and the stock market go hand in hand.
But small, regular investments don’t necessarily come cheap because of brokerage fees.
Even discount brokers usually charge a minimum of $35 per trade. So the person in our example would have paid at least $175 in brokerage fees, which would amount to 12% of his total investment if he bought individual stocks. And if he invested in smaller increments, such as $100 monthly, the percentage cost would be much higher.
Mutual fund fees, on the other hand, are usually well-suited to the small investor. If the fund has a 5% load, you pay $5 when investing $100, $10 when investing $200 and so on.
