Saving for Retirement - Dollar Cost Averaging
The most basic principal of investing is to “buy low, sell high”. Unfortunately, putting that into practice is at best difficult and at worst a dangerous gamble. However, by using a strategy known as “dollar-cost averaging”, you will automatically buy more shares of a stock, mutual fund, or ETF when the price is low and fewer shares when the price is high. Your returns will be greater when your investment does well, and your losses limited if it drops.
Dollar-cost averaging simply means investing a fixed sum of money each month, regardless of price. When the share price of your investment is low, you will automatically buy more shares. If the price is high, you will buy fewer shares. Over time, your portfolio is automatically tilted towards cheaper shares. As a result, if the stock price drops, you lose less, and if it gains, you earn more.
For example, imagine that you chose to invest $4,000 in Gateway (GTW) on January 1st, 2005. We’ll call this Scenario A. The stock price plummeted from $5.85 to $3.06 over the next 12 months, and by December of 2005 your initial investment of $4,000 would have been worth $2092.31. Today, with Gateway trading around $1.94, you would have $1,326.49 to show for your investment. Lousy, huh?
Scenario A - $4,000 Lump Sum
| Month Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Sept 06 Future |
$ per share $5.85 $4.46 $4.63 $3.92 $3.44 $3.42 $3.27 $3.99 $2.73 $2.84 $2.74 $3.06 $1.94 $5 |
Shares Bought 683.76 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 |
Shares Owned 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 683.76 |
Inv. Value $4,000.00 $3,049.57 $3,165.81 $2,680.34 $2,352.14 $2,338.46 $2,235.90 $2,728.21 $1,866.67 $1,941.88 $1,873.50 $2,092.31 $1,326.49 $3,418.80 |
However, in Scenario B, look at how dollar-cost averaging could have reduced your loss: If you had invested $333.33 each month through the year, rather than plunking down $4,000 on January 1st, your investment would have only dropped to $3,484.23. Today it would be worth $2,208.96. You could have saved yourself a loss of nearly a thousand dollars!
Scenario B - $333.33 per month
| Month Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Sept 06 Future |
$ per share $5.85 $4.46 $4.63 $3.92 $3.44 $3.42 $3.27 $3.99 $2.73 $2.84 $2.74 $3.06 $1.94 $5 |
Shares Bought 56.98 74.74 71.99 85.03 96.90 97.46 101.94 83.54 122.10 117.37 121.65 108.93 0.00 0.00 |
Shares Owned 56.98 131.72 203.71 288.74 385.64 483.11 585.04 668.58 790.68 908.05 1,029.71 1,138.64 1138.64 1138.64 |
Inv. Value $333.33 $587.46 $943.18 $1,131.88 $1,326.61 $1,652.23 $1,913.09 $2,667.65 $2,158.56 $2,578.87 $2,821.39 $3,484.23 $2,208.96 $5,693.20 |
And consider what would happen if the value of Gateway stock suddenly rose to $5 per share. Your investment under Scenario A would be worth $3418.80, a loss of almost six hundred dollars. Under Scenario B, your investment would be worth $5,693.20 - a hefty gain!
Dollar-cost averaging makes sense as an investment strategy for long-term savings, such as retirement or other long term goals. To take advantage of dollar-cost averaging in your retirement savings, simply have the “minimum payment” that we determined yesterday tranferred each and every month into your retirement account and you will automatically hedge against falling prices and reap more rewards when your investments flourish!
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| This entry was posted on Tuesday, September 26th, 2006 at 11:12 am and is filed under "The Plan", Retirement, Investment. You may e-mail this post to a friend. You may print this page. You can leave a response, or trackback from your own site. | ||
October 11th, 2006 at 8:33 am
In your scenario, the stock is constantly going down with little exception, but on the exceptions it would be better to dollar cost save. By that I mean, if the stock goes up, we save our cash, if it goes down, we buy…like this:
Date Shares Bought Total Shares Cash
Jan 05 56 56 $5.73
Feb 05 76 132 $0.10
Mar 05 0 132 $333.43
Apr 05 170 302 $0.36
May 05 97 399 $0.01
June 05 97 496 $1.60
July 05 102 598 $0.21
Aug 05 0 598 $333.54
Sep 05 244 842 $0.75
Oct 05 0 842 $334.08
Nov 05 243 1085 $1.59
Dec 05 0 1085 $334.92
Future $5 stock price = 1085 shares = $5425 + $334.92 cash = $5,759.92 or a gain of $66.72 over dollar cost averaging.
BUT since in Sept 06 the stock dropped to $1.94, you had no cash, I have $334.92 left, so…
Sept 06 172 shares bought, 1257 shares total with $1.24 cash. That puts us at a total of $6,286.24, which is $593.04 more than dollar cost averaging, AND we have more shares than the dollar cost averager as well, so we’ll continue to make more profit than the dollar cost averager going forward.
Invest in peace…
October 13th, 2006 at 4:03 pm
Steve, you are correct. Any strategy that puts more dollars in when the stock is low and fewer when the stock is high will result in a higher profit if the stock goes up, and less loss if it drops.
Your strategy does involve timing the market, however, and if you judge incorrectly (that is, postpone an investment when the price goes up, only to have the price continue to gain) you expose yourself to additional risk.
Your strategy also requires that the investor dedicate some time every month to evaluating how much to invest. If you have an interest in managing your investments and don’t mind spending the time, following the strategy that you have set forth makes good sense.
However, dollar cost averaging avoids both the additional risk and additional time committment. If you are new to investing or simply don’t want to devote any more time than necessary, making fixed contributions each month or quarter is a great way to get started and build significant savings over time.