Dollar Cost Averaging: A Better Way to Save?

This a guest post on dollar cost averaging, a strategy I think works especially well for “ordinary” investors with small amounts of money who want to build a nest egg over time.

Wait! Don’t hit the back button just yet. I know that there’s a lot of bad publicity on dollar cost averaging, but let me lay out both positive and negative argument first. My basic point here is to show you when and how to use DCA to maximize your investments.

Definition

Dollar Cost Averaging (DCA) is an investment strategy that requires investing equal monetary amounts periodically in a certain stock or portfolio over a certain time period. A simple dollar cost averaging plan could be something like buying $100 worth of Wal-Mart (WMT) stock every month for the next five or twenty years. The idea behind this is to lower the total average cost for the shares purchased over time because more shares are bought when prices are low and less shares are bought when prices are high.

Pros

The main advantage of this approach is the fact that it lets you “ease into” an investment. It doesn’t require you to have a large amount of capital to get started in investing. This is perfect for individuals who currently don’t have a lot of cash, but can set aside a small percentage of their income for investing on a consistent basis.

Another advantage of DCA, as I mentioned above, is that it lowers your total average cost per share. Since this program lets you buy more shares when stock prices are low, and less shares when prices high, your cost per share will thus “average out”. This is argued to effectively reduce your risk on volatile swings in the market price (AKA bull and bear cycles).

Lastly, I’d like to point out that investors can use DCA to take advantage of compounding (earning interest on previous interests and principal) via Dividend Reinvestment Plans (DRIPs). These are basically direct stock purchase plans offered by companies to small investors who want to accumulate shares DCA-style over the long run. As the name implies, DRPs reinvest any dividends earned by shares into more shares, which is in a way, another form of compounding.

Since DRIPs are basically a form of DCA, I’d like to point out their major advantages for investors.

  • Starting is easy and cheap. You can enrol in a DRP with the initial purchase of just a single share.
  • Your investment is compounding, so it will grow much faster than regular interest-bearing instruments.
  • Some companies offer shares at a discount to their DRP investors, further lowering acquisition costs.
  • Regular investments can be as small as $10 to $50.
  • There are no brokerage fees (for company-run DRPs).
  • You are invested for the long-term, maximizing the power of compounding and eliminating the need to time the market (which can really be both frustrating and scary).

Cons

The number one argument against DCA is the fact that your investment will underperform against the rest of the market when prices are strongly trending up. This is because you can’t bet big now (and thus win big) with a DCA approach.

Another argument against DCA is that its benefit is small compared to the lost returns from waiting to invest the money over time. Of course, investing now is always better than investing tomorrow because your money can be put to work early and productively. That is, if you currently have money and if you’re certain that the instrument you’re investing in will be yielding a definite positive return (like with bonds, but not necessarily for stocks).

Examples

Here is a simple dollar cost averaging calculator. Just enter the ticker symbol of any company, a monthly investment amount, the start and end dates, and click “calculate returns” (this calculator doesn’t account for stock splits so the real ending dollar amount would be bigger than what will be displayed). I suggest you take it for a “spin” and try out some scenarios. For example, try looking at the end figures of some stocks in the Dow Jones Industrial Average if you put in $50 a month (with dividend reinvestment) for a period of 30 years going back.

If you try that for Citigroup (C), you’ll see that if you started buying $50 worth of Citigroup stock every month from June 1982 up to June 2012, you’d end up sitting on stocks worth $253,363.81 today. What’s amazing here is that the total dollar amount that you invested during the entire time period only amounts to $18,050.

Now try the calculator for other stocks like Coke (KO), IBM (IBM) or McDonald’s (MCD). As you may notice, some stocks will make you say wow and some will make you say woof. Of course, the results will vary depending on the stock you pick, so you still have to do your research. This just shows that DCA does not give you immunity against bad stock picking.

If you’re just starting out and itching to get some money saved and invested, you can try dropping that $3 Starbucks (SBUX) latte every day ($15 per week) and put the money in DRPs of solid, growing companies.

Jason S. Ramos is a contributing author for WealthLiftInsider.

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