What is Dollar Cost Averaging?

When it comes to investing, dollar cost averaging refers to investing an amount of money in a stock or mutual fund at regular time intervals. The idea behind this investment strategy is that you are getting a lower price when the market is down even though you are paying a higher price when the market is up and, overall, the average price you pay is lower than what get from investing a lump sum. At first, this may not look consistent with my previous post on The Golden Rule... of Investing: Buy Low, Sell High, but let's take a look at an example to see how you can benefit from this strategy.

Assume you invest $100 every month for five months into a given stock. The stock price at each of these purchase dates is as follows (with the number of shares purchased):

Jan.: $20 (5 shares purchased)
Feb.: $14 (7.1 shares)
Mar.: $13 (7.7 shares)
Apr.: $15 (6.7 shares)
May: $23 (4.3 shares)
Total: $85 (30.8 shares)

The $500 invested purchased 30.8 shares, resulting in a cost per share of about $16.23. This means that when the stock price is above $16.23, there is a gain on the investments.

But what if the May stock price was still down around $15 as it was in April; what are the results then?

Total: $77 (33.2 shares purchased)
The $500 invested purchased 33.2 shares, resulting in a cost per share of about $15.06. A gain would exist when the stock price is above $15.06. The May price is not above that price so there is no gain until the stock increases.

So what do we learn from these examples? That Dollar Cost Averaging is not necessarily going to give you better returns; it completely depends on the stock performance over the given period. So does that mean I should just invest the $500 all at once? Well, if you did that in Jan. in the example, you would be even worse off since your cost per share would be $20 instead of $16.23 or $15.06. If you invested the $500 in Feb. you would be better off with only a $14 cost per share. Since we don't know how a stock or mutual fund will perform, investing continuously over a period diversifies away much of the market risk (the risk of market fluctuations). Also, most individuals do not have enough money to make a single investment now to carry them through to retirement, but rather have smaller amounts set aside each month as income is received. Another way to take advantage of continuous investing is by reinvesting dividends rather than having them paid out. This can be done automatically by your financial institution or brokerage.

The Golden Rule... of Investing: Buy Low, Sell High

It sounds intuitive if you want to make money in the stock market, or anywhere else for that matter: buy low and sell high. The difference is your gain (or loss) on that investment. Even though it sounds intuitive, people often do not take advantage of the opportunity. The typical reaction to a slower economy is to sell stocks before the losses get any worse. This may be a good rule of thumb to avoid further losses if you are nearing retirement or are depending on that money in the near future, but what about long-term investors? This presents a great buying opportunity. The recent recession is obvious when looking at the Dow Jones Industrial Average over the past five years. Investing at the market low in March of 2009, would have resulted in some pretty hefty gains as of today. People often choose to stay away from riskier stock investments during a slow economy due to their volatility, but for the long-term investor, that can be the opportune moment to invest.

Make Interest Work in Your Favor

We often think of interest rates as the rate that we have to pay in the process of paying off a mortgage or other debt. Interest is a two-way road: those paying it are paying it to another party who is earning it. The best place to find yourself is on the earning side of interest. It can kill you when you have unpaid credit card debt because it never sleeps or takes a break, but if you have money invested in the right vehicles, it will also work for you.

I encourage you to keep a checking a savings account for your primary banking needs. Choosing the right bank or credit union depends on the interest you can earn and what free services are offered. Today, most basic checking accounts provide most services free of charge, but the savings accounts typically offer very low interest rates. As such, keep only the minimum amount of cash on hand at this institution to ensure you are not charged any fees as well as to cover your cash needs for at least a couple of months. The cash need can be determined based on your monthly expenses and should be there in the case that your income is stopped (due to loss of job or other emergency).

The remainder of your money should be invested wisely. Enough should be kept liquid in money markets to cover for a rainy day or rainy 6 months, but this can be at a larger institution such as Vanguard. Transferring money to your bank accounts can usually take place in a couple of days so the cash is close at hand, but is earning a much better rate of return. Vanguard is one of my favorite institutions as they have a wide range of investment choices and possibly the lowest fees of anyone.

Longer term investments are a whole different can of worms so I'll open that one up later in the future.