By Mary Jo Lyons
Last year there was a lot written about dollar cost averaging, an old school investment strategy. What I have found is that many investors don’t really understand what it means. So I thought I’d provide an overview in our series on investment basics.
What is it?
Dollar cost averaging (DCA) is buying a fixed amount of an investment at regular intervals regardless of price.
How does it work?
It works much like the process of investing in your 401k. You invest a lump sum in a specific investment at regularly scheduled intervals despite what may or may not be happening in the market. This assumes that you will be buying more shares when the price is lower and that over time your average share price is reduced. This is also very similar to the way a Dividend Reinvestment Plan (DRIP) works. In a drip plan an investor holds a position in an investment and then reinvests any dividend payments into additional shares, dripping more money in over time.
Is it right for me?
As is true for most things… That depends!
Earlier I said a lot was written about this recently. A large financial services firm did a study that got a lot of air play regarding the value of DCA in July of 2012. The conclusion was that investing a lump sum at one time rather than a little at a time results in a better long term return. This may be true IF you have a lump sum to invest. That isn’t the case for most novice or beginner investors. For them DCA is the only way to go.
For many investors DCA makes total sense. Here’s why. It’s emotional! You have heard me say that many times. What happens to the Psyche of an investor who has a lump sum and decides to jump in with both feet, only to experience a market correction of 25% the next day, week or month? This could result in a loss of principal that takes a long time to overcome. This investor may decide the market is too risky and decide to put it under the mattress for safe keeping instead. As a result this investor is never going to see the capital growth they will need in order to accomplish long term investment goals.
Consider the investor who has a lump sum to invest but decides to sit on the sideline waiting for the lowest possible point to jump in. If the market never takes a dip then this investor is sitting on the sidelines not participating in the upside. They may be thinking I’ll wait until tomorrow and then tomorrow never comes. Many people need the forced discipline that DCA provides.
For most investors this is how they have built wealth, by investing a little at a time over many years. If you are fortunate to have access to a company sponsored retirement plan such as a 401k or 403b, this is exactly how they work. You make a contribution on each pay period, and the plan sponsor invests it on your behalf based on your investment instructions. Over time you have the potential to save a sizeable sum of money for retirement. It’s that simple.
If you do have a lump sum and are considering investing, I encourage you to just do it. If this makes you uncomfortable then consider a modified DCA strategy. Split your lump sum into 3 or 4 equal amounts and set up a standing order to invest each portion on a specific date of the month or day of the week. Don’t try and time the market, pick a plan and stick to it.
Just do it!
* Because dollar cost averaging involves continuous investment in securities regardless of fluctuating prices, the investor should consider his or her financial ability to continue purchases through periods of falling prices, when the value of their investments may be declining. Dollar cost averaging does not ensure a profit.