Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 49)

Dollar Cost Averaging

by

Charles Lamson

Dollar cost averaging is the single most powerful investment strategy that most individual investors can use to achieve their financial goals. It works because it takes full advantage of compounding and a continuous presence in the market.

With dollar cost averaging, you are buying no matter what the market is doing. That may not sound like a conservative investment strategy on the surface, so let me explain what dollar cost averaging is and does.

The essence of dollar cost averaging is putting a fixed amount of money into the market every month. If you have a 401(k) or 403(b) plan at work, you are practicing dollar cost averaging right now.

I will use mutual funds as the investment target for this explanation, but you can do this with individual stocks; I will show you how later this post.

Say you have $100 a month to invest, whether it is through your retirement plan or your own investment program. Every month $100 is invested in a mutual fund regardless of whether the fund is up or down.

The dollar cost averaging philosophy is not concerned with the price of a fund when it is time to invest. The result is when the fund is up you buy less and when the fund is down you buy more. Over time, you will achieve a good average cost basis for the investment.

It will not be the ideal return. The ideal return depends on buying heavily when the fund is at its lowest, while avoiding buying when it is at its highest. If you recognize this as market timing, go to the head of the class.

Your bonus question: Who can consistently time the market correctly? That is right: no one.

I also want to emphasize that dollar cost advertising works best over a long time frame. This is where you need courage to ride out the low spots even if they occur right after you get started. Few investment strategies work well over a short period of time, and dollar cost averaging is no exception.

It is also important to note that if you buy a turkey, it will be a turkey, even if you buy it using dollar cost advertising. If you buy a stock for its growth potential, but it is not showing any signs of growth, follow up with a check on Morningstar.com of their analysis of the stock. When no one believes in the stock it is probably time to cut your losses and move on to another opportunity.

If you read investment books or wander around the Internet, you are likely to find discussions about using dollar cost averaging to invest a large sum of money. For years, it has been suggested that if you have a large sum to invest (an IRA rollover or inheritance) that it is best to invest it over a period of time rather than all at once.

Now people are saying that may not be a good strategy. We will explore this use of dollar cost averaging a little later, but for now, let us assume we do not have a lot of money to invest at once. A number of sources raise the question: "Would it be better to invest $2,400 at once or $200 a month for 12 months?"

That is not a question that many of us in the real world would care about, because we do not have $2,400 sitting around. What we can do is free a sum of money each month to invest. Ken Little contends in his book, Alpha Teach Yourself Investing in 24 Hours, you are better off in the market than out and it is better to invest money as it is available rather than wait until you have saved a big chunk.

Initial Deposit

Most mutual funds require you to come up with an initial deposit of $2,000-$3,000. This amount is often less for IRA accounts, but may still be $1,000. If you have the money to make this size of initial deposit, your choice of mutual funds is fairly broad.

However, we noted that many of us do not have an extra $3,000 lying around. You can still get in the market, because there are mutual funds that will let you open an account for a couple hundred dollars. These are not crummy funds because they have low entry points, but there are fewer out there so your selection is not as large.

Automatic Deduction

Once you are in a fund, plan on setting up an automatic deduction from your checking account each month. Almost every fund out there will do this for you and many actively encourage it. Some will lower their initial deposit if you set the account up this way from the beginning.

The automatic deduction from your checking account enforces a disciplined approach to investing that is sometimes compromised when you have to write a check each month.

When your account is large enough, you can move into another fund if you are not happy with the fund you are currently in.

When you have more money to invest on a monthly basis, consider increasing your monthly deposits or opening another account with a different fund.

Dollar cost averaging is an effective, long-term investment strategy that just about anybody can participate in. It keeps you investing regardless of the market and takes away the issue of timing the market.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 304-306*

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