There are many different types of systematic savings plans for mutual funds, but dollar-cost averaging is perhaps the most well-known. This simple strategy has been used by thousands of investors to improve the overall rates of return that they receive in their investment programs.
What Is Dollar Cost Averaging?
Dollar-cost averaging is simply a method of purchasing shares of a mutual fund on a monthly basis. The same dollar amount is used each month to purchase fund shares month in and month out for typically a long period of time, such as from one to ten years. Many company employees use this strategy in their retirement plans when they purchase shares each month with their elective salary deferrals. This method differs from other types of systematic investment plans in that the monetary amount used every month is identical instead of the number of shares purchased. Of course, this strategy is limited to open-ended mutual funds that allow for the purchase of fractional shares.
The dollar cost averaging strategy is important to mutual fund customers because it allows them to set up a long-term plan that will not require their attention on a monthly basis. A regular purchase of shares of stock or other securities will typically require the investor to decide the number of shares to be purchased and then place an actual trade, while dollar-cost averaging is the investing equivalent of “auto pilot”.
See also the 7 Questions to Ask When Buying a Mutual Funds.
The Appeal of Dollar-Cost Averaging
Dollar-cost averaging is popular with investors for two reasons. In addition to the long-term convenience described above, it also usually lowers the average overall cost of the shares that are purchased and thereby improves the rate of return for investors. Below, is a dollar cost averaging example:
Dan starts a job with a new employer and signs up for their 401(k) plan. His salary is $60,000 per year and he defers 10% of his income into the plan and uses the money to buy shares of ABC growth fund. $500 is therefore deducted from his paycheck each month and used to purchase shares of this fund. He pays the following prices for his shares over the first year:
|Month||Price per share||Number of shares purchased|
Total number of shares purchased = 410.3789
Average number of shares purchased per month = 34.1982
Average monthly cost per share = $14.68
If Dan had simply purchased $6,000 worth of shares in December, then he would have only ended up with 388.0983 shares. By spreading his purchase out over the year he was able to pick up an additional 22.2806 shares for the same amount of money. Of course, if he had spent his entire annual contribution in any month from April through August, he would have gotten a better deal, but this moves us into the realm of market timing.
The real advantage here is that Dan bought more shares in months when prices were lower and fewer shares when prices are higher. The advantage of this becomes more apparent over the long-term, where we can see that Dan will reap a profit of $2,207.58 if his shares reach $20 in price. If he had bought all of his shares in December, the lesser share amount would only come to $1,761.97 of gain from the purchase. And if these shares pay any form of current income, such as interest or dividends on a regular basis that are reinvested, then this difference will continue to widen over time.
Furthermore, this can all be achieved without having to try and time the markets in any fashion, which in and of itself can require a substantial amount of time and effort to accomplish even when you succeed at it. This same principle is also applied to portfolio rebalancing strategies, where shares of appreciated securities in a given portfolio are sold off and the proceeds used to buy more shares of another section of the portfolio where prices are depressed.
Risks and Limitations
Although DCA strategies may give the investor a lower cost compared to some lump-sum purchases, it won’t do so all of the time. As mentioned in the previous paragraph, Dan would have done even better if he had made a lump-sum purchase in any of the five months from April through August. And while this would require him to follow the markets on a monthly basis, the fact is that he would have come out better with a lump-sum purchase for almost half of the year.
Some financial pundits decry DCA strategies as purely a marketing tool that fails to provide investors with any type of superior return over time and also does nothing to reduce the investor’s real risk. DCA has also showed itself to offer little advantage over a buy-and-hold strategy during longer periods of stagnant or declining markets. Some studies have also shown that DCA strategies lag those of lump-sum investing over long periods of time. Another possible disadvantage from DCA is that, while it is convenient, it also allows investors to ignore the markets, which may prevent them from taking action at times when they should.
The Bottom Line
Regardless of its true effectiveness, dollar-cost averaging strategies will continue to be recommended and used by a large percentage of mutual fund investors worldwide, particularly those who are saving for retirement with systematic investment plans. Although this strategy can be effective at times, historical data clearly shows that it is not always the best approach.
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