Monday, April 19, 2010

Dollar Cost Averaging Part I

Doesn't help to stay up late to make sure I have a post for Monday and then not set the date correctly. Sorry for being late again.

Markets have ups and downs and its near impossible (if not impossible) to predict the swings. People often panic when the markets crash like they did in 2008. In fact if not for panicking and greed there probably wouldn't be very much money to make on the stock market. So with this volatility, how can we safely invest in the market.

When I first heard about Dollar Cost Averaging (DCA), I was impressed with the simplicity and power of it. For simplicity I'll talk about stocks, but I'm more likely to hold mutual funds myself. What you are investing isn't that important when discussing this technique. By investing a set amount every month, you buy more stock when the price is low and less when the price is high. You don't need the stock to rise above what you initially paid. It only needs to rise above your average.

Here's an example (modified example from the Wealthy Barber):
Let's say you decide to invest $100 a month in XYZ company.
Month 1 the stock price is $10/share, so you buy 10.
Month 2 the stock price is $5/share, so you buy 20.
Month 3 the stock price is $7.50/share, so you buy 13.33 (Yes, you can actually buy 1/3rd of a share).

So, even with the share lower than your original purchase price you have 43.33 shares at 7.50/share. You spent $300 and your stocks are now worth approx. $325. Even with the share price down, you've still made money.

The theory sounded great, but I wanted to know how it works in real life. I found an online calculator for dollar cost averaging and ran it against several different stocks and they all came out ahead in the end. I should have bookmarked it, but it didn't really interest me because I don't invest in common stock and it didn't work with mutual funds. My personal funds are doing OK, but I don't have any numbers for 2008 as I wasn't investing at that time due to limited funds.

The biggest benefit to knowing this method is the piece of mind it brings. When the market goes down, you're picking up stocks for a bargain. While others are panicking, you're profiting off of their sales. If you're investing though, you really don't have much of a choice other than to invest in a small fixed quantity. We're not going to come up with our retirement money all in one deposit, so we have to do it in small increments. You can tell people you're dollar cost averaging, but really you're just investing the only way you can. Just keep your head and stick to the plan and you'll come out fine on the other end.

Keep in mind we're talking long term investing here. If you need the money in the next 5 or so years, this probably isn't the best place for you and it's time to move at least what you need, into something less volatile.

Next I'll talk about dollar cost averaging when you come into a larger sum of funds.

Anyone continue putting money in through the recent crash? How are your funds doing now? Did Dollar Cost Averaging work for you?

No comments:

Post a Comment