Slow But Steady: Dollar Cost Averaging

04/18/2003 12:00 am EST

Focus:

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

"Investors are lousy market-timers. I've told you many times before that huge wads of cash have moved into bond funds just before a decline, and moved out of bond fund just before a rally. Well the same holds true for equity funds. Right now, investors are putting the bulk of their money into bonds and little into stocks. The exact opposite occurred at the peak of the stock market. Right now, I know they are wrong, and you probably know in your heart of hearts they're wrong, but what can be do about it?

"Here's the answer: Get back to basics. And one of the most basic of all investment practices us something called dollar-cost averaging, or DCA. With the bear market long in the tooth and investors beginning to throw up their hands in disgust, it's time to go over one of the more basic investment strategies that you can use to stay in the market, poised for a rebound. Dollar-cost averaging will help you laugh in the face of a downturn, endure up-and-down markets, and still grow your profits reliably over the long-term. It is one of the easiest and most effective investment plans you can follow, and if you invest in a 401(k) or any other plan where regular contributions are made monthly, weekly, or even semi-annually you are already engaged in a form or dollar-cost averaging. And that's great, so long as you keep at it.

"One of the reasons I wanted to bring up DCA now is because people are apparently pulling out of their retirement plans, or just investing less in them as the bear market continues to prowl. According to a report in The Wall Street Journal, 2002 was the first time in a decade that the number of workers participating in 401(k) plans dropped (from 77% in 1999 to 73% in 2002). In addition, more and more young professionals now entering the workforce are not even enrolling in retirement plans. Unfortunately, they are precisely the ones who could reap the greatest gains from investing now, while stock prices are low, The reason this trend is important to combat is that spending now, rather than saving a regular amount in a retirement plan can seriously jeopardize our future quality of life. Investors who cut back on their contributions to retirement accounts risk having to work longer, risk outliving their savings, and risk seeing dreams of a comfortable twilight go up in smoke, I know that this is ground I've covered in the past, but until, I start seeing indications that folks are smartening up, expect to hear it from me again.

"So let's go over why DCA is so important. Whether you are investing in a 401(k) plan, putting money into your IRA, or maybe trying to figure out how to put that cash you're hoarding to work, dollar-cost averaging is right for you. While I've always been an advocate of lumpsum investing when someone has a long time horizon for their investments, I still love DCA. In particular, I love it when investors are at the ends of their emotional pendulums-either worried to death or irrationally exuberant. Dollar-cost averaging avoids the emotional trauma of sticking a lumpsum into the market at just the wrong time. It also acts as a forced savings/investment plan. Rather than putting a lumpsum of money into the market you make smaller purchase over a longer period of time. This is where 'averaging' comes into the strategy, by buying shares over time, you average out your cost per share as your fund's price invariably rises and falls. Dollar-cost averaging also allows you to overlook short-term dips and bumps with the assurance that you will come out okay in the end-the longer your time horizon the better your investment outlook will look. Another benefit is purely psychological- even in lean months when your performance suffers, because you've kept adding money to your investment, the total value of your account will continue rising in all but the very worst bear-market periods.

"Another benefit worth noting is that the number of shares you end up holding will often be greater with a DCA plan than if you were to invest a larger sum of money all at once in a fund. You are constantly adding shares to your portfolio, and when performance lags, you're getting more shares for your money, bringing a lot of extra value to your investment when things start to get better. This constantly increases your profit potential as you stick with the program. So let's take a look at DCA in action in periods when the markets are at their absolute best and absolute worst. I'll focus on the stock market since this is where investors have been shying away and where DCA could provide the best profit potential going forward.

"As you are well aware, most stock market indexes hit their peak in March 2000 and have been in a fairly steady decline since. But suppose you'd started investing precisely at the top of the stock market. There are two ways you might have put that money to work. For the sake of this example, let's assume a hare and a tortoise both have $5,000. The hare takes the money and puts it all into the stock market, on the last day of February, 2000. The tortoise, by contrast, starts off slow putting $100 into the stock market, and leaving the balance in a Treasury money market fund. Then, every month the tortoise adds, like clockwork, another $100 to his account. What would have happened during one of the worst bear markets in history? Yes, both the tortoise and the hare have less than $5,000, but the hare's account has dropped to $3,070 and he's thinking about having to eat day-old carrots for the rest of his life. By comparison, the tortoise's account has declined to $4,530, of which $1,810 is still in his money market account. The hare is ready to give it up while the tortoise still has reserves ready to invest if prices continue to descend. But let's freeze their accounts here. What we know is that it will take just a 10.3% gain in the market for the tortoise to be back at $5,000 and on his way to profits. The hare, by comparison, will need to see a 63% gain to get back to $5,000. By the time that happens, the tortoise's account, assuming no additional investments in the stock market, will be worth almost $7,400.

"Obviously, we don't have a clue what the market will do today, tomorrow, or in a week or month, but I am fairly certain that a strategy of regular contributions into the stock market will result in a higher return over time than a strategy of sitting on your cash or investing in the peaking bond market. When you don't know what the market is going to do (and a great majority of people don't at any given time), a DCA strategy takes out a lot of the risk, because it is constantly averaging out your gains with your losses while increasing the number of shares you hold of whichever fund or stocks where you employ the strategy. Unless you have a crystal ball telling you how to time your entries and exits from the markets-whether bond or stock-perfectly, one of the best investment plans you can consider is one that includes dollar-cost averaging. If you're already investing regularly in you retirement account, keep doing so. If you've slacked off because you are nervous about the market, consider this- would you rather lose some money in the short term while positioning your investments for future growth or keep your money 'safe' for now but risk having to work until you're 80 to support yourself. For me, the answer is clear. Add to your retirement account now, while prices are low and values are high, and worry less about the short term, keeping your eye on the future, and a cushy retirement. If your goal is building future wealth, today is a better day than we have had in almost three years to put some money to work."

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