Have you ever heard the phrase, “half the battle is just showing up?”
Saving systematically is kind of like that.
You’re also probably already doing it too in your 401(k), IRA or other retirement plans. In the financial planning world we call this simple, yet effective strategy, dollar cost averaging.
Dollar Cost Averaging
Dollar Cost Averaging or DCA is when you systematically invest into a portfolio. You’re removing the emotional pitfalls of trying to time the market.
Face it; you are your worst enemy when it comes to investing.
The ups and downs of the market can affect your investment performance. Dollar cost averaging spreads out your investment buys over time, thus potentially reducing your investment risk.
Dollar Cost Averaging in Action
Here is an example. Let’s say you invest $500 into the market at intervals of $100 per month. In the first month, let’s assume the share price is $20, and you buy five shares. The following month the price per share drops to $10. Now, your $100 investment can buy ten shares, twice as many. The third month the share price drops further to $5 and allows you to buy twenty shares with your $100 purchase. In the fourth month, the price per share rises back to $10, and you buy ten shares again. The fifth and final month, the price per share rises back to $20, and you can buy five more shares with your $100 investment.
Investing your $500 over the five months has netted you 50 shares at the current share price of $20. That’s a total of $1,000 netting you a gain of $500.
Investing all your money on the first month would net you a return of zero.
While this example only shows a market that went straight down and back up it’s an illustration to help you understand the potential benefits of dollar cost averaging.
Is Dollar Cost Averaging Right for Everyone?
Over time, the example shows what occurs in the short term. Expectations of growth over long historical returns would prove fruitful following the dollar cost averaging strategy.
Dollar cost averaging isn’t meant to discredit or replace value investing or technical analysis strategies. Their entirely different strategies and can sometimes work well together.
A poor investment is still a poor investment regardless of the buying or selling strategy you use.