Take the emotions out of investing
Dollar-cost averaging may help your investments work smarter.
Most people view a sale as an opportunity to buy more of what they need, whether it’s cereal, shoes or a washing machine. Yet when the stock or bond market declines, people tend to put the brakes on their investing program. And when the markets are heading higher, many of us want to pile in – ignoring the possibility that things are becoming overvalued.
But what if there were an easy way to take the emotions out of investing – and make your investing more consistent in the process?
Systematic investing can help
If you make regular contributions to your IRA or 401(k) plan, you’re already a systematic investor. That is, you invest the same amount at the same time, whether with each paycheck or month or quarter.
Dollar-cost averaging, or DCA, follows the same principle. With DCA, you send the same dollar amount to a mutual fund on a regular basis, typically through an automatic transfer from your bank account. By making the investments automatically, you remove your emotions from the equation. If the market is up that month, you invest $100 – or whatever amount and frequency you choose. If the market is down that month, you still invest $100, without worrying about the possibility of a bear market.
DCA may provide the positive effect of making your money work smarter. You automatically buy fewer shares when prices are rising and more shares when prices are declining. As in the other areas of your life, you may seek to take advantage of sales and avoid paying full price. So when most people are running away from a market decline, you may be picking up value. And when greed takes over and everyone wants to invest aggressively, you resist the urge to splurge.
DCA lowers your average cost per share
But DCA has another potential benefit. Because the prices of investments fluctuate over time, the systematic investor will typically wind up with a below-average cost. By buying a larger number of lower-priced shares and a smaller number of higher-priced shares, the ultimate cost per share will be lower than that of the investment vehicle itself.
The following table illustrates how this might work in practice. A hypothetical investor sends $100 per month to a mutual fund. The hypothetical fund’s price per share varies between $21 and $18 over the course of the year. This means that the investor’s $100 can only buy 4.76 shares in February, and as many as 5.56 shares in June.
|Investment Date||DCA Investment||Share Price||Number of Shares Purchased|
At the end of the year, the investor owns 61.79 shares of the fund. The average price paid for each share is $19.42. In contrast, the average price per share of the mutual fund over the 12 months is $19.46. The investor achieved a better price through DCA, and that savings may lead to a better return on the investment over time.
Note that the more volatile the investment price, the greater the potential for DCA. So when you’re investing systematically, market volatility may, ideally, become something to appreciate rather than to fear.
Other potential benefits of DCA
Systematic investing may be beneficial for those who are new to investing or can only save a small amount. DCA allows neophyte investors to get in the habit of investing regularly. Many mutual fund companies waive their investment minimums for DCA programs, allowing people to make a manageable contribution to their funds.
Over time, even modest contributions could compound, potentially putting you on the path toward your investment goals. Best of all, DCA keeps the focus on the long term, rather than the day-to-day fluctuations of the market.
A word of caution: DCA only works if you stick with it. If you turn off your systematic investments during a bear market, you won’t reap the potential benefit of those lower prices. Also bear in mind, DCA does not guarantee against investment losses in a volatile market – fund shares may be worth less than their original cost upon redemption.