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Building Wealth: Using The Dollar Cost Averaging Strategy
by Dr. Scott Brown, Advisory Panelist
Thursday, April 2, 2009: Issue #970
Many know dollar cost averaging is a series of equal dollar investments made at regular intervals. But it can also be used as one of the most powerful ways to build wealth.
I know a beautician named Sharon who ran a shop out of her house in a small mountain community. Living off of her husband’s salary, she took what she made from cutting hair and invested it – through dollar cost averaging.
Those haircuts added up. She and her now retired husband are living in their dream home.
Quite simply, dollar cost averaging is a straightforward and functional strategy that can be used by anyone from investment experts to novices. Instead of investing a lump sum all at once, you invest equal amounts at regular intervals over a period of time.
But there’s more to this strategy than meets the eye…
Dollar Cost Averaging – Investing With Small Consistent Amounts
Dollar cost averaging is used by large mutual funds and institutions that have hefty portfolios already, or individuals – like my friend above – who save and invest with small, consistent amounts. In short, everyone can use this timeless strategy.
If you ran a mutual fund or large institutional asset pool, you invariably would have to buy stocks in bigger quantities. But, for example, if you place an order for one million shares, everyone else would know that you’re buying.
They would rush to buy shares and drive up the price before your purchase went through.
To prevent this, many professional traders and funds will make numerous smaller purchases when building up a large position in a stock. This prevents anyone from knowing how much stock you’re buying. And because the amounts are spread out, it lowers the chance that they’ve timed their purchase incorrectly.
Building Wealth: Dollar Cost Averaging Lowers Cost Per Share
For investors who may not have the time, energy or knowledge to time their transactions, the dollar cost averaging strategy can lower your average cost per share by spreading out their purchases.
For example, let’s use a smaller investment amount to illustrate -$5000 (the annual limit for Roth IRAs). If you invested $5,000 into an index with a $50 net asset value (NAV) at the beginning of the year, you’ve purchased 100 shares.
But let’s say you spread those purchases out in $417 monthly increments. And let’s say that index has been fluctuating over the course of the year with a range of $41 to $57.
Here’s how it looks…
|
Beginning of Month |
Dollar Investment |
NAV |
Shares Purchased |
|
1 |
$ 417 |
$ 50 |
8.33 |
|
2 |
$ 417 |
$ 44 |
9.47 |
|
3 |
$ 417 |
$ 41 |
10.16 |
|
4 |
$ 417 |
$ 41 |
10.16 |
|
5 |
$ 417 |
$ 44 |
9.47 |
|
6 |
$ 417 |
$ 50 |
8.33 |
|
7 |
$ 417 |
$ 56 |
7.44 |
|
8 |
$ 417 |
$ 50 |
8.33 |
|
9 |
$ 417 |
$ 41 |
10.16 |
|
10 |
$ 417 |
$ 50 |
8.33 |
|
11 |
$ 417 |
$ 56 |
7.44 |
|
12 |
$ 417 |
$ 57 |
7.31 |
|
Total |
$ 5,000 |
|
104.95 |
Because of the choppiness of the share price, your dollar cost averaging strategy allowed you to purchase 4.95 more shares during the same period with the same investment amount. Imagine if you could increase all your investments by 4.9%…
Dollar cost averaging reduces the risk of buying your investment at its highest point:
- By making multiple purchases, you’re bringing your average cost per share down.
- In addition to simply being a way to lower you costs, it’s practical as well.
- Very few of us start out the year with the full amount of funds we have to invest over that year.
Start with a consistent amount (many brokerages will allow transactions as small as $25) and set up a regular investment schedule. For newer investors, it’s one of the easiest and best ways to build great wealth.
For more experienced investors looking to get back into the market, it’s the perfect way to rebuild or start new positions without a confirmation that we’ve hit a bottom or not.
It should be a lesson for the millions of Americans who believe they can’t get started investing until they have a large amount saved up. You can start small, you can start smart – and you can come out on top, just like Sharon.
Dollar Cost Averaging – Limitations To This Wealth Building Strategy
There are some limitations to dollar cost averaging. And many of its opponents are quick to point them out. As a strategy, dollar cost averaging works best in mixed, uneven or choppy markets.
- If you were going into a sharp downturn, the best strategy would be to wait as long as possible before getting back in.
- On the other hand, if the market was going to move straight up, you would want to put all of your money in as quickly as possible.
- But the fact of the matter is that no one knows what the markets will do tomorrow, next week, next, month or any period of time in the future. So as intelligent investors, we need to choose a strategy that will allow us to maximize our returns – regardless of Wall Street’s direction.
It’s why dollar cost averaging is so flexible and appropriate for the market conditions right now.
It can be done on any timeline. Some investors cost average for a day, others for a year. You choose the timeline that’s most appropriate for your needs. The net result is that your average cost should equal the average price during that period.
And lower costs mean higher profits.
It all starts with education,
Dr. Scott Brown
Today’s Investment U Crib Sheet
Our Fourth Pillar of investing is minimizing investment expenses and taxes. And while we focus on fees and sales expenses (often related to selling) dollar cost averaging is an easy way to minimize the amount you pay for the investment itself.
But let’s look at some of the other ways you can cut back:
- On the expense side, that means avoiding investments that carry front-end loads, back-end loads, 12b-1 fees or surrender fees.
- There’s nothing we can do to affect a stock’s performance once we own it. But there is a way for us to guarantee our portfolio will be worth more five, 10, or 20 years from now. All we have to do is cut our expenses… and stiff-arm the taxman. (Legally, of course.)
- On the tax side, it means reducing what the IRS is entitled to take. We can do that by avoiding actively managed funds in non-retirement accounts, owning high-yielding investments in tax- deferred accounts, and buying high-quality investments (high quality = less turnover = less capital gains taxes).
- Dollar Cost Averaging
- Investment U & The Oxford Club: Empowering Investors & Building Long-Lasting Wealth
- Insider Buying: The Best Buy Signal You Can Get
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3 Responses to “Building Wealth: Using The Dollar Cost Averaging Strategy”
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Dr. Brown specializes in teaching stock investing because as he emphasizes "the stock market is where individuals and families have the best shot at succeeding financially!"
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April 2nd, 2009 at 3:02 pm
Dollar averaging is a technique promoted by institutions to keep people invested long-term without deliberately managing their investment. Is Investment U favoring this?
Anyone suspicious of this notion should read “Invest Like A Shark” by James ‘RevShark’ DePorre. Anyone who wants to make serious money would NEVER use dollar averaging.
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April 2nd, 2009 at 5:33 pm
1) Did Sharon pay taxes on her “Hair cutting” money?
2) My trades cost about $20.00. 12×20= $240.00.
seems like I get less shares per year.
George Pitonyak
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April 7th, 2009 at 7:11 pm
I agree with your comments on Dollar Cost Averaging. But you neglected to advise that each separate investment has a brokerage charge each time you buy into a stock and that will reduce your gain.I don`t usually buy mutual funds except for the GOne Fishing Fund, so I don`t know what the mutual Funds charge each time you make an additional investment.
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