Friday, August 28, 2009

Dollar-Cost Averaging

“Dollar-Cost Averaging” is one of the most commonly known and understood investing strategies. But everyone hears about it a first time, even you.

When I first heard about dollar-cost averaging I was attending a financial planning seminar in Killen, Texas. I was a young married Army Lieutenant with a mortgage but no children. The seminar was sponsored by Fidelity Investments.

A round wooden disk with the letters “TO IT” printed on one side in bold black letters was found on every chair when we arrived. After pitching the benefits of systematically making monthly purchases of the Fidelity Destiny mutual fund the presenter concluded the seminar by telling us that we had no excuse now that he had given us all “a round to it”. Then he scheduled home appointments with many of us, including me.

In the end, I signed up. For two and a half years a monthly allotment was automatically deducted from my Army paycheck and invested in the Fidelity Destiny fund. Because of the systematic dollar-cost averaging of my fund purchases and because I waited another two years before selling my shares this was my first, and for many years my only, successful investment. It was successful despite a 20% front end load which means 20% of every monthly purchase was skimmed off and given to the sales person (the seminar presenter) as a commission.

So what is this magic “dollar-cost averaging”? It is simply the fact that the price of your chosen investment instrument will fluctuate and if you make regular equal dollar amount investments in the same financial instrument you will sometimes pay a high price and sometimes you will pay a low price. When the price is high you buy fewer shares but when the price is low you buy more shares.

Because the average price you pay is always less than the highest price your investment risk is reduced. You will not inadvertently put all of your money into your investment at the highest price, nor will you get an accidental windfall by putting everything in at the lowest price.

For most people, like me then and now, dollar-cost averaging is not an intentional strategy. It is the result of a payday saving plan – like contributions to a 401k account.

However, if you happen to have a lump sum to invest, remember dollar-cost averaging and consider using it to put your lump sum into one or more investments using multiple purchases over an extended time period. Markets will fluctuate. What goes up must come down and what comes down is likely to go up. But don’t think you know what the market will do tomorrow. Sometimes you will be right. Sometimes you will be very wrong.

No comments:

Post a Comment