Dollar Cost Averaging
What is dollar cost averaging? Simply, it is a systematic investment plan where one constantly puts a fixed amount of money into a mutual fund on a regular, predetermined, scheduled basis. This has several positive advantages. First, it locks one into the discipline of regular investing, “forcing” one to save. If you enroll in your 401(k) at work for example, money will be deducted and invested for you before you even have a chance to get your hands on it for bad spending habits. Second, it takes the emotion out of the picture and decision process. Thirdly, when the market is up you buy less shares, when the market is down, you purchase more for your money. You have heard the old maxim, “buy low, sell high”—and purchasing more shares when the market is down allows you to have more shares in your account when the market goes back up.
Dollar cost averaging can work particularly well with a fund in a flat or down period, and then recovers to go higher-- as opposed to going up steadily over time. See example below:
Which Scenario has more shares at year-end?
This illustration is meant to show that more shares can be purchased in a market downturn. 86.47 shares x the final price of $19.50 at year-end in Scenario B is more than 152.63 shares at the year-end price of $10 in Scenario A ($1686.16 vs. $1526.30). But if shares are held for longer time periods and the market goes up even more, then all was not lost in the situation with Scenario A during the first year and can come out ahead since a greater number of shares were able to be purchased when the market was down.
There are countless situations and scenarios that can be examined, some better than others. In one situation Scenario A comes out ahead. In other situation, Scenario B comes out ahead. The variables and factors are endless. But the point, which must be learned, is that disciplined, regular investing over the long term, can truly build wealth and retirement savings. A plan of action is better than no plan at all.