Not many people today think about getting their money into equity markets, but they should. As Warren Buffett says, “Stocks are on sale.” But if you have a lump sum you want to invest, what should you do? Just invest it all together in one lump sum? Many investment advisors would counsel against it. They’d tell you to dollar cost average into the market.
Dollar cost averaging is an investing technique intended to reduce the risk inherent in placing money in the market with a single large purchase. Doing so is risky, of course, because we don’t ever really know which way the market is headed and we want to avoid the risk that the market happens to be high and poised for a fall just after we put all our money in.
So, the idea with dollar cost averaging is simple: spend a fixed dollar amount at regular intervals (e.g., monthly) on a particular investment or portfolio regardless of the share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high.
Here’s an example. Let’s say you want to put $100,000 into an S&P Index fund. You decide to dollar cost average and divide your $100K into eight equal amounts to be invested every 90 days. Here’s the result:
| Periodic Amount | Purchase Date | Share Price | Shares |
| $ 12,500 | 01/01/09 | $ 105 | 119 |
| $ 12,500 | 04/01/09 | $ 110 | 114 |
| $ 12,500 | 07/01/09 | $ 106 | 118 |
| $ 12,500 | 10/01/09 | $ 100 | 125 |
| $ 12,500 | 01/01/10 | $ 97 | 129 |
| $ 12,500 | 04/01/10 | $ 92 | 136 |
| $ 12,500 | 07/01/10 | $ 90 | 139 |
| $ 12,500 | 10/01/10 | $ 98 | 128 |
| Average: $99.33 | Total Shares: 1007 |
If the future were accurately reflected in the above chart, at the end of two years you would have 1,007 shares of the S&P index fund at the average cost of $99.33 per share. In this case, your decision to dollar cost average would be rewarded. The S&P index fund happened to be at a high when you established your investment plan. If you had invested all of your $100K on January 1, 2009, you would have just 952 shares and a cost basis of $105 per share. Instead, you have 1,007 shares and a cost basis of $99.33 per share. The result? Your investment is worth $98,664.83 rather than $93,333.33. Nice.
If the S&P index had risen continually after January 2009, your strategy would have lost money. Unfortunately, you don’t know what the future holds. That’s why many people espouse dollar cost averaging.
Note: The example above assumes the investor places money in the market for a long-term hold, i.e., buy and hold vs. trade. Dollar cost averaging is a means for getting money into the market for a buy-and-hold strategy, i.e., a time horizon of greater than five years, not a trading strategy.
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2012.
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