If you’re not disciplined, you’re not going to reach your goals. You say want to start exercising so you can lose 10 pounds and look great on your summer vacation. Unfortunately, lifting a Big Mac to your mouth doesn’t qualify as exercise.
Same goes for investing. You can say you want to start saving money, but until you actually start saving on a regular basis, you’re not going to get anywhere. This is why many investors follow a disciplined approach to investing and one reason many financial professionals recommend a “dollar-cost averaging” strategy to their clients as a means of achieving long-term growth of capital. The dollar-cost averaging strategy historically has offered investors benefits in the face of market fluctuations, enabling them to invest at an approximate average cost over time.
What Is Dollar-Cost Averaging?
The idea behind dollar-cost averaging is simple. Instead of trying to guess the timing of market lows and then “jumping in,” you regularly invest a fixed dollar amount in an investment over a long period of time. You follow the same regularity whether you’re investing in a single investment or a selection of similar investments, such as stocks, bonds or mutual funds.
Since dollar-cost averaging focuses on long-term results rather than the short-term value of your holdings, prevailing market strength or weakness at the time you begin to invest isn’t the crucial factor. What’s more important is that you choose a realistic dollar-cost averaging program based on your individual financial situation and then stick to your plan.
How It Works
As a hypothetical example of how dollar-cost averaging might work to your advantage, assume you invest $500 in a particular stock every quarter. If shares of that stock sell for $10 each, your first quarterly investment would purchase 50 shares (excluding commissions). If the price falls to $5 per share at the time of your second $500 quarterly investment, you’d buy 100 shares. If the stock rose to $15 in the third quarter, your next investment would purchase 33.3 shares. Assume that by the fourth quarter, the stock is back to $10 per share. You’d then buy 50 more shares.
Where would you stand after investing at these varied prices? You’d own a total of 233.3 shares, purchased for a total investment of $2,000 ($500 per quarter). With an ending market price of $10 per share of stock, however, your shares would actually be worth more than you paid for them ($2,333.50 in total current value compared with your $2,000 purchase price).
If you view this strategy from another perspective, you’ll see that the average price per share for the four quarters ($10 plus $5 plus $15 plus $10 divided by 4) would be $10. But the average cost to you would be only $8.57 per share ($2,000 divided by 233.3 shares).
Note: This example is for illustrative purposes only and doesn’t take into account any sales charges or commissions associated with purchasing these shares.
Financial Discipline Is the Key
Your ability to stick with your original investment plan, regardless of changes in market conditions, is the key to dollar-cost averaging. Naturally, this approach doesn’t guarantee a profit or protect against loss in a declining market. You should also consider your ability to make regular investments through periods of low prices before using this strategy. However, following a dollar-cost averaging plan of action can help to keep you from missing out on the market when it’s low and only investing when it’s high.
Writer Thaddeus Toal is a Certified Financial Planner based in Annapolis, Md., and can be reached at (410) 349-4916 or by e-mail at [email protected] You can also visit his Web site at www.toalfinancial.com.
This article doesn’t constitute tax or legal advice. Consult your tax or legal advisor before making any tax-related or legally related investment decisions. This article is published for general informational purposes and isn’t an offer or solicitation to sell or buy any securities or commodities. Any particular investment should be analyzed based on its terms and risks as they relate to your specific circumstances and objectives.