Retirement FAQ

What is dollar cost averaging

Does dollar cost averaging really work to my advantage?

Answer

Dollar cost averaging will almost always work to your advantage.

Essentially, dollar cost averaging is the systematic purchase of shares of stock or a mutual fund with the same dollar amount each month.  If you contribute to a 401(k) plan you are, in essence, dollar cost averaging your investment.  When the share price increases, that dollar amount will buy fewer shares; and when the price decreases, the dollar amount will be more shares.  When done over a long period of time, this has the effect of averaging down the cost basis of the shares so that your net investment is always going to be less than the current share price.

Here is an example of a $500 monthly investment in a mutual fund over the course of a year:

Month Price # Shares
Jan $25 20
Feb $24 21
Mar $23 22
Apr $21 24
May $20 25
Jun $22 23
Jul $23 22
Aug $25 20
Sep $26 19
Oct $27 18
Nov $27 18
Dec $28 17

At the end of one year, you would accumulate 249 shares at an average cost of $24.25.  The ending share price is $28.  Even though the share price was below the initial price for six months of the year, the ending account value increased by $972 over your $6000 investment for a return of 16%.

This strategy should provide some comfort to investors who go through severe stock market declines, as was experienced in 2008-2009.  Investors who were able to stick with a dollar cost averaging strategy throughout the decline reaped the rewards when the market turned around over the next four years.

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