The power of dollar cost averaging
Take a look at this chart. If you had $1200 to invest, which investment would you buy?
For most people, the answer is obvious. Investment A is the most consistent and also has increased the most. With investment A, your investment has gone from $1200 to $2400. Investment B would have grown to $1800 and Investment C would have recovered to the original $1200 investment.
But what if you invested $100 per month instead of the $1200 all at once right at the beginning? Now which investment would give you the best return? Believe it or not investment C would be the winner giving you a portfolio value of $1741.27 while investment A and B would both end up at about $1595. When investing regularly, dollar cost averaging can work in your favour.
What is dollar cost averaging?
Dollar cost averaging is really an investment concept where you systematically invested a fixed amount of money periodically to buy investments with a fluctuating price. The easiest way to understand dollar cost averaging is to look at the math of investment C:
Let’s say you are going to invest $100 per month into this mutual fund that has a starting price of $10 per share. When prices drop, investors often get concerned because the value of their portfolio drops. However, with dollar cost averaging, investors systematically take advantage of price drops by buying more units of the same investment. As you can see in the example below, as the price drops in the first 7 months, more and more units are being bought every month.
|Month||Dollar amount invested||price per share||units bought||cumulative units|
The power of dollar cost average happens when the price rebounds and comes back because you now have more units working for you. It’s really just math. You can see this in month 12 when the price comes back to the starting price of $10, the portfolio has grown to $1741 from on a $1000 of total contributions.
|Month||Dollar amount invested||price per share||units bought||cumulative units||Cumulative Value||Amount invested|
Dollar cost averaging is an investment strategy that helps investors fight the emotions of a downturn in the markets and potentially profit from systematically buying low when prices fall.
Group savings plans and dollar cost averaging
Members of group savings programs automatically take advantage of market fluctuations and especially short term downturns through dollar cost averaging. If you belong to a workplace plan and the markets are correcting, rest assure that every new investment is taking advantage by buying more units which will really benefit when markets rebound.
Brilliant. Putting dollar cost averaging in graphical form. It sure looks ugly to end at the same place that you start, but the power of DCA is indisputable in such a situation.
Math is really cool when you can see it at work!
Great example of dollar cost averaging. Dollar cost averaging is an average investor’s best friend. It’s easy to do and you don’t have to stress out with every market dip.
There’s no question about it, dollar-cost averaging is a great tool for investors to harness as they work towards their goal of financial independence.
I recently started to synthetically DRIP within my registered accounts and over the long-term, reinvesting dividends when the share price fluctuates will allow me to take advantage of dollar cost averaging.
Great post Jim!
This article muddles up what the choice of actions is. All the DCA options delivered value below that which would have accrued if you bought 100% of either A ($2400) or B ($1800) at the start.
The example changed the subject from a) comparing 100% to DCA purchases, to b) comparing DCA outcome for stocks with different future price movements.
Chris is right!