What Is Dollar Cost Averaging?
The dollar cost averaging strategy is important to mutual fund customers because it allows them to set up a long-term plan that will not require their attention on a monthly basis. A regular purchase of shares of stock or other securities will typically require the investor to decide the number of shares to be purchased and then place an actual trade, while dollar-cost averaging is the investing equivalent of “auto pilot”.
See also the 7 Questions to Ask When Buying a Mutual Funds.
The Appeal of Dollar-Cost Averaging
Dan starts a job with a new employer and signs up for their 401(k) plan. His salary is $60,000 per year and he defers 10% of his income into the plan and uses the money to buy shares of ABC growth fund. $500 is therefore deducted from his paycheck each month and used to purchase shares of this fund. He pays the following prices for his shares over the first year:
|Price per share
|Number of shares purchased
Average number of shares purchased per month = 34.1982
Average monthly cost per share = $14.68
If Dan had simply purchased $6,000 worth of shares in December, then he would have only ended up with 388.0983 shares. By spreading his purchase out over the year he was able to pick up an additional 22.2806 shares for the same amount of money. Of course, if he had spent his entire annual contribution in any month from April through August, he would have gotten a better deal, but this moves us into the realm of market timing.
The real advantage here is that Dan bought more shares in months when prices were lower and fewer shares when prices are higher. The advantage of this becomes more apparent over the long-term, where we can see that Dan will reap a profit of $2,207.58 if his shares reach $20 in price. If he had bought all of his shares in December, the lesser share amount would only come to $1,761.97 of gain from the purchase. And if these shares pay any form of current income, such as interest or dividends on a regular basis that are reinvested, then this difference will continue to widen over time.
Furthermore, this can all be achieved without having to try and time the markets in any fashion, which in and of itself can require a substantial amount of time and effort to accomplish even when you succeed at it. This same principle is also applied to portfolio rebalancing strategies, where shares of appreciated securities in a given portfolio are sold off and the proceeds used to buy more shares of another section of the portfolio where prices are depressed.
Risks and Limitations
Some financial pundits decry DCA strategies as purely a marketing tool that fails to provide investors with any type of superior return over time and also does nothing to reduce the investor’s real risk. DCA has also showed itself to offer little advantage over a buy-and-hold strategy during longer periods of stagnant or declining markets. Some studies have also shown that DCA strategies lag those of lump-sum investing over long periods of time. Another possible disadvantage from DCA is that, while it is convenient, it also allows investors to ignore the markets, which may prevent them from taking action at times when they should.
The Bottom Line
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