Actually I love anything that gives my investment portfolio a legitimate edge. There is beauty in the simple and dollar cost averaging (DCA), or systematically investing into your 401k for example, is elegantly simple.
Actually, if you are contributing to a 401k/403b or similar there is a good chance you are already enjoying the investment benefits of DCA. Let’s examine why this is benefiting you.
At some point in the past, you (hopefully) filled out a form electing to contribute a certain amount of your hard earned paycheck directly into your employer’s retirement account. (For the sake of this article, let’s assume you are contributing to a 401k.) Generally, you elect to contribute a flat dollar amount or a specific percentage of your paycheck to your 401k. Let’s assume that you are paid every two weeks, 26 times per year. Let’s also assume that you elected to contribute $200 per paycheck to your 401k ($5,200 per year). To keep things simple we will also assume that you opted to put your $200 contributions into a S&P 500 Index Mutual Fund, a broad representation of large US companies.
Every two weeks, before you see any of your paycheck, a $200 deposit is made into your 401k account. Immediately, that $200 purchases shares of that S&P 500 Index Mutual Fund. Let’s assume that at the moment, shares of this mutual fund are priced at $50 per share. Quick math tells me that you would purchase 4 shares ($200 divided by $50). Two weeks later, if the shares of that mutual fund were still priced at $50 per share – meaning the US Stock market hadn’t moved much, you would again buy another 4 shares.
Here is where the fun starts. Let’s assume that two weeks later, there is talk of the US going to war with a new middle eastern threat and this causes the stock market to take a big dive, a 20% drop to be exact. Those shares you have been buying for $50 per share are now priced at $40 per share. Now how many shares does your $200 contribution buy you? Yep, 5. The stock market went on sale and without having to do anything on your part – your DCA system automatically bought you a bit more…perfect! It works the other way as well. If the US Stock market races forward by 20% and your mutual fund is now priced at $60 per share, your $200 contribution only buys you about 3.3 shares. As you can see DCA systematically buys you more shares when they are cheap and fewer shares when they are expensive. Think about it – f you went to the grocery store and found that your favorite soda pop was on sale would you buy more or less of it? DCA gets our investing mentality on the same page as our consumer mentality – buy more when things are cheaper, buy less when they are expensive. Elegantly simple.
Now, can you see why I love Dollar Cost Averaging.
Chris Costello, CFP®
Published on July 16, 2014