How Does “Dollar Cost Averaging” Work To Improve My Investment Returns?

“Dollar cost averaging” sounds like a mysterious accounting term that requires a degree in business to understand. It isn’t. Not only will this short article explain the concept completely, it will also help you understand that you may already be doing it and that it is likely helping your long-term savings plan.

Dollar Cost Averaging: This phrase refers to the idea of investing the same amount of money each month (or week, or every two weeks) in a mutual fund (stock, bond, ETF, REIT, etc.).

By investing the same amount each month in something with a fluctuating price, like stocks, bonds, REITS, ETFs, etc., you accidentally get a small benefit over the long haul. You are likely to buy more shares than if you bought in one big lump or, even worse, tried to “time the market” by buying when prices are low.

You see, what happens when you buy the same dollar amount each period is that in the periods when the price is high, you acquire fewer shares or units. In the periods when the price is low, you acquire more.

Consider this example:

If you bought $100 worth of shares each month on the first day of the month in a mutual fund initially trading at $20, you’d buy 5 shares on the first day. If the price moves up to $25 for the next month, you’d acquire only 4 shares. If the price drops to $16.67, the next month, you’d acquire 6 shares. Maintaining this discipline over time will generally increase your returns over buying in bigger lumps—if you can avoid transaction costs.

The worst thing to do is to try to beat the system by timing your purchases. Consider the scenario above. Presume that you had the courage to monitor the price for three months before making a purchase of $300 all at $16.67. That sounds brilliant, right? Not so brilliant if the price drops to $10 the next month. Often people make the bigger mistake of letting price momentum carry them away in a rush of panic, investing everything at $25—expecting the price to continue climbing.

The great thing about dollar cost averaging is that you are already doing it if you are contributing to a 401k. Every paycheck, a little bit of money is deducted for a contribution to the 401k. It is invested on a strict schedule. No one tries to time the market and you are getting the full benefit of dollar cost averaging.

If you aren’t already participating in your 401k, start today! If your employer doesn’t offer a 401k, you can easily get the same benefit by scheduling contributions to a mutual fund each month. As your assets grow, you’ll likely hold your mutual fund investments in a brokerage account. Most discount brokers allow you to invest even small amounts in certain mutual funds with no transaction fees. Note that all of the benefits of dollar cost averaging are overwhelmed by brokerage commissions or mutual fund loads. Avoid them.

See how easy that was. Dollar cost averaging is something you’re probably already getting the benefit of and now can fully understand.