Dollar-Cost Averaging is an investment strategy where an investor makes periodic purchases of an investment, regardless of the assets price. When an investor contributes to their employer-sponsored retirement plans (403(b), 401(k), 457) each paycheck, dollar-cost averaging is done automatically. The goal is to reduce the impact of volatility on the overall investment purchase and take advantage of price fluctuations.
When an investor contributes to an investment account individually, funding an IRA or non-qualified investment, investors are often quick to write a check towards the account, funding with a lump-sum contribution. There can be benefits to dollar-cost averaging over time, which lump-sum contributions miss.
Let me take a step back and review the simple basics of investing in the stock market.
- When investing, you either invest in individual stocks or mutual funds.
- Many investors invest in mutual funds (used in employer-sponsored retirement plans) compared to individual stocks.
- Mutual Funds invest in approximately 200 different stocks at a time, and you are buying and investing in the group.
- Mutual fund prices are calculated daily, derived from the value of the underlying stocks. This is called the price per share.
- When the stock market increases, prices increase, and investor’s see gains in their accounts.
- When the stock market increases, investors buy fewer shares with their investment contribution.
- When the stock market decreases, prices decrease, and investor’s see losses in their accounts.
- When the stock market decreases, investors by more shares with their investment contribution. Think of this as an opportunity to buy low.
- With each contribution, mutual fund shares are purchased. Prices fluctuate daily.
Let’s compare 2 investors making a $6,000 contribution into the same investment during the year.
- Investor A contributes $6,000 in a lump-sum contribution
- Investor B contributes $1,500 quarterly.
Date
|
Investor A | Investor B | ||||
| Price per Share | Investor Contribution | Shares Purchased | Price per Share | Investor Contribution | Shares Purchased |
January 1 | $27.27 | $6,000 | 220 | $27.27 | $1,500 | 55 |
April 1 |
|
|
| $28.00 | $1,500 | 53.57 |
July 1 |
|
|
| $23.85 | $1,500 | 62.89 |
October 1 |
|
|
| $25.00 | $1,500 | 60 |
Total shares owned | 220 | 231.46 | ||||
In this example, prices fluctuated throughout the year,
- Increasing April 1 to $28.00 per share
- Decreasing July 1 to $23.85 per share
Notice how the shares purchased related to the price.
On December 30th, the price per share is $26.50; lower than the price January 1. To calculate the account balance, multiply the price per share by number of shares owned.
Investor A
Owns 220 shares at the end of the year. Their account balance on December 30th is $5,830. A loss of $170 due to the price per share decrease of $27.27 on January 1 to $26.50 on December 30th.
Investor B
Owns 231.46 shares at the end of the year. Their account balance on December 30th is $6,133.69. They own enough shares to make up for the loss posted by the investment, due to the price per share being less than it was January 1. As a result, their account is positive for the year.
Prices fluctuate and no one can predict the future, dollar cost averaging may provide an opportunity for the investor throughout their investing career. Please do not hesitate to give me a call if you wish to discuss further.