What is Dollar-Cost Averaging? And Does it Help Your Returns?

What the hell is dollar-cost averaging!?!?!?!?! A fancy way of saying equal contributions over a period of time, could be weekly, monthly or quarterly. The goal is to prevent you from buying at the peak of the market ("Time Penalty") when prices are inflated and ease the pain of the inevitable bear markets.

Have you ever purchased a stock and watched it subsequently fall? That's the "Time Penalty" at it's finest. If you're guilty of "Time Penalty" don't feel like your the only one, during the year 2000 cash flow into mutual funds hit an all time high as the market peaked. Again during 2002, the market trough, investors pulled their money out of the market. Even most recently in 2008 and 2009, the greatest buying opportunity of our lives, more money left the market than ever before. The dollar-cost averaging strategy removes the emotions of aggressively selling or buying in times of duress or euphoria.

Not only will dollar-cost averaging reduce some of your risk, it makes saving easier. If you can only afford $50/paycheck or $100/month (which doesn't sound like much initially) over 30 years that measly $100/month earning 8% will be $150,000 (while you have only invested a total of $36,000). Saving $200/month will yield $300,000, assuming you have $0 in savings to start. Again the beauty of compounding interest shows its amazing growth.

There is one downside to the dollar-cost averaging strategy; if the market consistently increases over the years, without any bear markets or downturns. In the example below, both funds are using the dollar-cost averaging strategy but Fund A increases in price month after month and Fund B declines at first but rebounds to end the year at the same initial stock price ($100).

One can see at the end of the year the total investment for Fund B is more than Fund A even though Fund A ended the year at a higher stock price ($124.29) than Fund B ($100). Fund A would have fared better if all the $12,000 was invested in month one but, how many times has the market consistently rose year-after-year without any downturns? In the past 15 years we have had two corrections; one in the summer of 2000 (50% decline) and the other in October 2007 (56% decline). The dollar-cost averaging strategy will not protect you from those large, exacerbated declines like 2000 and 2007 but, it will definitely improve your overall return on investment (ROI) like the Fund B example.

I once heard an analogy describing the behavior of the stock market as a boy walking up a hill playing with a yo-yo. The short increases and decreases in the market (the yo-yo) are still rising overtime (the boy walking up the hill). You can, and should, increase some of your monthly contribution when you think the market is severely oversold, just not everything you have all at once. But remember, your in the market for the long haul, investing for the hill not the yo-yo, so try to suppress your emotions. Burton Malkiel claims, "For the stock market as a whole (not individual stocks), Newton's law has always worked in reverse: What goes down has come back up."

Let's recap;

• Dollar-cost averaging is simply a fixed contribution at equal intervals over a period of time.
• A small contribution each month ($100) can grow to a large sum of money overtime, $150,000 in 30 years earning 8% a year.
• Dollar-cost averaging helps smooth out some volatility in the short term stock prices and prevent's buyers from committing "Time Penalty".
• Keep some extra cash on the sidelines to invest during the bear markets.