Friday, October 29, 2010

How to Get Rich Slowly DRIP by DRIP: What's Dollar-Cost Averaging Got to do with It?

Dollar-Cost Averaging is a fancy term for a series of regular equal value investments into the same product over an extended time regardless of the product’s changing price.

Generally, people make equal periodic investment purchases for their own convenience; they match their buys with their employer’s payroll cycle. People with 401k plans, including me, are almost always dollar-cost averaging into their 401k investments for example.

So what? Who cares?
Virtually no one can successfully time the market over a long period. You can’t always correctly predict the price of your chosen investment in order to buy when it’s low and sell when it’s high.

Since you really don’t know which way the market will go in the near term, if you make a single lump-sum investment you may accidentally buy just before the price goes up. You may also buy just before the price crashes.

One reason to Dollar-Cost Average is to reduce the price direction risk of a fixed dollar investment. Spread your $10,000 lump-sum investment as 10 monthly investments of $1,000 each and you'll find the entry prices of each of the 10 investments are different. Some are higher and some lower than the first purchase.

The hope is that your average price is better than your single lump-sum price would've been.

Happiness is a Volatile Share Price
But, there’s another advantage of long term Dollar-Cost Averaging – the kind available thru monthly DRIP account purchases. The Excel workbook below shows the number of shares that would be purchased and their value if equal annual investments were made in a DRIP over 25 years with all dividends reinvested. It also assumes that the DRIP stock increases in value at a consistent 6% rate every year.

6% Constant Annual Earnings Per Share Growth

After 25 years of $600 annual investments the investment grows to $63,563.21 with 448.54 shares in the account at a presumed market price of $141.71 per share. The sum of the annual investments is only $14,994.05 – a pretty good return overall.

The next Excel workbook shows an example of what happens in reality. The stock price doesn’t grow steadily every year. Instead it bounces around. Sometimes up. Sometimes down. But, in the end, it reaches the same price - $141.71 per share.

6% Average EPS Growth with Volatility

The difference is each annual $600 investment buys either more shares or less as the share price fluctuates.

The example has 6% average annual growth but with fluctuations of 18.12% up or down around the average. The result is an ending value of $77,916.60 with a total of 549.83 shares in the account.

Try it for Yourself
Obviously, I forced the ending share price to be the same by tweaking the fluctuation percentage. You can change the parameters in the workbook to see how different values of average growth or the volatility (fluctuation percentage) affect the outcome. But the typical case is that volatility, as long as some of it takes the price below the average increase curve, will result in more shares held in the end.

That’s why Warren Buffet says to be happy when share prices fall – Mr. Market is just holding a sale!

The next post will take up the idea of “diversification” in DRIP accounts.

Link to Topics in the Special Report - How to Get Rich Slowly DRIP by DRIP


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