Continuing on in the 3 Investment Principles series (If you haven't caught the first two here they are: Time Value of Money and Pay Yourself First) we come to the final principle: Dollar-Cost Averaging (DCA). The aim of DCA is to reduce the risk associated with a single, large investment by spreading out the investing (and risk) over time. Everyone has heard the token financial advice, "buy low, sell high." Seems simple enough, but in reality no one can predict exactly when a stock will bottom out. By investing a fixed dollar amount at regular intervals (weekly, monthly, etc.) regardless of share price, you will end up buying more shares when the price is low and less when the price is high, thereby maximizing your total return.
An example of this from youngmoney.com:
"Dollar cost averaging works like this: systematic investments are made to an investment account. For this example we will say on a monthly basis. To keep things simple we will also say that the investment account is allocated 100% into one growth fund. We will use $100 as the monthly investment amount. Now, depending on how the market is doing that fund's price is going to fluctuate from day to day. So let's look at a six-month example in the table below.
Month | Price | Shares Purchased |
| 1 | 20 | 5 |
| 2 | 16 | 6.25 |
| 3 | 10 | 10 |
| 4 | 5 | 20 |
| 5 | 10 | 10 |
| 6 | 25 | 4 |
In the example above, you have invested $600 and your account is now worth $791.73. Over the six-month period, you paid an average of $14.33 per share. If you would have taken all $600 and purchased the shares at the beginning of the six months, you would have purchased 30 shares and your account would now be worth only $750. For this example, using dollar cost averaging has increased your account by over 5%! Of course the above scenario is just one example of using dollar cost averaging. There are many."
This isn't to say that this method of investing doesn't have its critics. DCA operates on two assumptions: 1) the investment (stock, mutual fund, etc.) follows an overall positive trend over the investment time frame, meaning, dollar-cost averaging isn't going to help if the investment you're putting money into ends up losing value in the long run. 2) If you happen to get extremely lucky and start investing at the bottom of a long-term price trend you would be better off buying a lump sum...good luck timing the market!! John Wagonner explains in USA Today, "Dollar-cost averaging typically does best when an investment goes sideways or down for years and then, at the end of the period, suddenly breaks to the upside."
As is the case with nearly everything in finance, time frame matters. "Regardless of the amount of money that you have to invest, dollar-cost averaging is a long-term strategy," explains Jim McWhinney for Investopedia.com, "While financial markets are in a constant state of flux, they tend to movie in the same general direction over fairly long periods of time. Bear markets and bull markets can last for months, if not year. Because of these trends, dollar-cost averaging is generally not a particularly valuable short-term strategy."
In the end I like DCA for one simple reason, it builds a habit pattern of investing in season and out of season. Its very easy to form the wrong habits in an affluent culture like our own. It seems everyone, but you, always has the latest gadget, toy, car, etc. Spending, saving, investing are all habits. The purpose of this 3-part series on investment principles is to help make good habit patterns, ones that create wealth and enable you to live the High Life.
