Dollar Cost Averaging: Investing in Turbulent Markets

If you’ve been following the financial markets at all recently, you know that things have been turbulent. For many people, all this turbulence is scary. After all, how do you know when to put your money in the market — and when to pull it back out?

The good news is that you don’t actually have to know when to put money in and pull it out if you consider using an investing strategy called dollar cost averaging. It’s a strategy that works for long term wealth building using the stock market.

What is Dollar Cost Averaging?

Quite simply, dollar cost averaging requires you to invest a regular amount of money, at regular intervals. Many people choose to invest a set amount of money each month. A good example of this is automatic investing through your Thrift Savings Plan, 401k, or other allotments.

Most investments, whether individual stocks or funds, will allow you to buy partial shares. So, if you have $300 each month that you want to invest in an index fund with a price of $126 a share, you would be able to purchase 2.38 shares.

Every month, you invest that $300 (usually the help with automation), and you purchase as many shares as your money will buy on the day the order goes through. So, if the share price goes up to $150 a share, you will buy two shares. However, if the price falls to $100 a share, your investment will purchase three shares. The benefit is that you aren’t buying as many shares when the price is high, and you are buying more shares when the price is lower (remember, the goal is to buy low, sell high).





The idea behind dollar cost averaging is that, eventually, it all evens out in terms of overall cost. Sometimes you will pay less for your shares, and sometimes more, depending on the market. The important thing with dollar cost averaging is investing consistently.

Why Should You Consider Dollar Cost Averaging?

The reason that dollar cost averaging is so effective is due to the fact that you can get started fairly easily, and with a small amount of money, and consistently invest over time. You don’t need a huge amount of capital to get started. You can start a TSP account of 401k plan with as low as 1% of your salary, and some plans even allow you to begin investing with less than that. For example, many online brokers will let you get started with an initial deposit of between $25 and $100, and a monthly investment of between $25 and $50. You can set it up so that your investment comes out of your bank account automatically, each month, on a certain day. Most brokerages will also allow you to make a recurring investment, so your investing is totally automated.

Throughout all this time, you are investing consistently. Even when the market is down (more shares for your money!), you continue to invest. Historically, the market rises over time. With a buy and hold strategy that involves an index fund or a very carefully chosen stock (consider a dividend aristocrat; many online brokerages will automatically reinvest your dividends without charging a transaction fee), you can build your wealth gradually, benefiting from the fact that you are consistently buying shares. For most of us “regular” folks, that’s the best we can hope for — and it’s a fairly tried and true way to build wealth while limiting risks.

There is still risk involved in investing, of course, and you still need to be careful. However, you can reduce some of your risk, and build a consistent nest egg, if you follow a dollar cost averaging strategy.




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Date published: November 9, 2011.

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Miranda is a journalistically trained freelance writer and professional blogger working from home. She is a contributor for Mainstreet.com, Personal Dividends and several other sites.

Comments

  1. I used to think DCA was one of the unassailable ideas in finance, but I’m not so sure anymore. I don’t think of your example of $300/mo as dollar cost averaging, because you don’t have the alternative of lump sum investing. If you look at it as the alternative to saving $300/mo for a year then lump sum investing that $3600 at the end of the year, then maybe. I like to think of it as if I just won $3600 in a lottery and instead of investing it all, I decide to put in $300/mo for the next year. The problem is, I have to expect the market to trend upward, else why would I be investing. All DCA can do for me is lessen the likelihood of buying at a peak above the average cost over the 12 months. In return, I also lose all possibility of buying at the bottom, as well as the benefit of some compound interest over that 12 months and any dividend payments made during that period.

    I invest every penny I can afford monthly, because I believe in capitalism and expect the market, in the long run, to increase, so I want my money to work as long as possible for me, as time is my greatest asset. If I have a lump sum of unallocated money, I do my best to invest that as well.

    Like I said, I don’t know if there is a final answer, and one could make a valid argument for DCA. I just don’t see it as an undeniable truth like I used to.

    • AG, There have been studies done that show lump sum investing is typically better than dollar cost averaging. An example would be maxing out your IRA ($5,000) on January 1st, vs spreading the $5,000 investment out over 12 months (sorry, I don’t have a reference to the study, it was a couple years ago when I read it). Basically the study looked at past performance in the marketplace and ran simulations of investing in a lump sum on January 1st, compared to monthly investments, and the lump sum almost always won.

      That said, it doesn’t mean DCA isn’t a viable investment option. The fact of the matter is that not everyone can invest in a lump sum on January 1st (or any other date), and the monthly contributions of dollar cost averaging is still a good option in the long run. The other major consideration with DCA is that most people do it via automatic investments, which means people are investing regularly – and that is half the battle.

      I think the key here is to be able to invest regularly, and if you have a long term horizon, a well balanced investment portfolio will work for you more often than not.

    • William Sturm says:

      Stock markets are vulnerable at these levels. Too much corruption and manipulation. To believe in Capitalism is great. But we don’t really have that anymore. In Lichello’s development he did a 10-yr mutual fund with buy and hold versus his approach and he demonstrated more than a million with his AIM versus buy and hold which ended up at the same $10,000 at the end of the period.

      Astounding.

      wb

  2. William Sturm says:

    Dollar Cost Averaging is a ploy by the brokerage industry to continuously earn commissions. Sure it can be proven to work.

    But a much better alternative is provided by Robert Lichello, ‘How to Make
    $1,000,000 in the Stock Market Automatically” (4th Edition). ISBN 0451-20441-7 . Unemotional approach that works wonders. One pitfall is to pick a stock which goes bankrupt! Of course one can do it with an index fund or something that will never go bankrupt! A good gold or silver mutal fund is an acceptable alternative. But never buy SLV or GLD since these are only metal following index funds and they probably hold little or no metal to back up the notion that one ‘acutally owns’ physical metals.

    wb

    PS: The happiest day for a “Lichello” is when the market crashes. He suggest once a month the account be rebalanced per his AIM system. I suggest that it be rebalanced in addition when large moves take place!

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