Section II - Lesson 5D
Investing Basics - Understanding Risk: Dollar Cost Averaging
We've previously stated that time, diversification, and the timing technique of dollar cost averaging will virtually eliminate the risk of owning common stocks.
We've talked about the effects of a long-term investment horizon, and the importance of diversification. It's time now to discuss dollar cost averaging.
Dollar cost averaging, as we use it, is a descriptive name for the very simple timing technique of investing a fixed dollar amount every month into your S&P 500 Index fund. This technique works magic for a long-term investment program that makes repetitive purchases of a single widely diversified mutual fund, as we intend to do with the S&P 500 Index fund.
When you buy a fixed dollar amount of the same fund every month, you will buy more shares when the price of that security is lower, and fewer shares when the price of that security is higher. Your "average cost" of that security is favorably influenced by the fact that you bought more shares at low prices than you bought at higher prices.
Let's say you are saving and investing a fixed dollar amount of $300 every month. If the price of your index fund is $10, you'll be able to buy 30 shares. If the price rises to $20, you'll only be able to buy 15 shares. And if the price rises to $30, you'll only be able to buy 10 shares. You automatically create the result that you want, which is to keep your average cost as low as possible.
Dollar cost averaging is an ideal timing technique for the long-term index fund investor. It’s simple, automatic, and idiot-proof. We don’t have to guess at when to buy, or whether to increase or decrease the amount of our purchase. We simply buy the same dollar amount every month and refuse to let our emotions get in the way of making good decisions.
Dollar cost averaging in concert with long-term investing and broad diversification eliminates the risks of owning common stock. Your average cost, during your 20 to 30 year period of accumulation, will be considerably less than your average selling price, in later years, as you gradually withdraw your savings to meet retirement needs.
Dollar cost averaging, like broad diversification, should be a built-in feature of your long-term investment programs, which call for regular, automatic monthly purchases of an S&P 500 Index fund. In both your investment accounts, the dollar amount you purchase every month, or every pay period, will be the same except when you increase it to a higher level after getting a raise or changing jobs.
We’ll talk more about the use and benefits of dollar cost averaging in a later lesson as we use it to avoid timing decisions when faced with lump sums that need to be invested, such as bonuses, inheritances or other types of windfalls.
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