The Problem with Dollar-Cost Averaging
For the last 18 months or so the investment markets have been up and down and up and down, and are now pretty much at the same levels they were 18 months ago. A lot has happened, but nothing has happened.
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It's at these times in the longer-term investment cycles that the idea of dollar-cost averaging seems to be a timely topic. So let's take some time to analyze just how and when this idea works, and perhaps when it doesn't work as well. You might want to see how this will impact you over time.
Dollar-cost averaging is a fundamental investment concept that enjoys general overall acceptance. Here is a basic example of how it works:
If we invest $100 every week, say on each Wednesday, into a mutual fund (understanding that each week there will be a different price for the shares of that fund), we know that if the price is up, we'll buy fewer shares for that $100. If the price is down, we'll be able to buy more shares. If the price week one is $14.56 per share for the fund, we buy 6.868 shares. Next week, the price is $14.02, and we buy 7.133 shares--more shares because the price was down. If in the third week the price has jumped up to $15.12 per share, then our $100 buys only 6.613 shares.
That's a total of 20.614 shares for our $300, or an average of $14.55 per share. That's exactly how it works. Your methodical weekly investment buys more shares when the price is down and fewer shares when the price is up. It averages out over time. So far, so good.
Virtually all of the conversation about this concept seems to end here. It is assumed it doesn't matter if the price goes up or down, that it will average out over time. Mathematically, that is correct.
Yet, over time, it will matter more and more what the price is. The basic assumptions of dollar-cost averaging will matter less and less.
Why? As noted above, we add $100 each week to the investment. That second $100 is a 100% increase above the initial investment. That's great. But by week three, that $100 is only a 50% increase. Week four: it's only a 25% increase. And so on.
Each week's investment becomes a smaller and smaller percentage when compared to the overall account value. After one year, you have invested $5,200, and your 53rd weekly investment of $100 equals only a 1.9% addition to all that you have invested up to that point.
This is not a bad thing. Investing is great. Consistent investing is great. But we now need to pay attention to the value of the total account, as price matters more and more with each weekly purchase. Of course, lower prices benefit us in the beginning since we can buy more shares. But continued lower pricing means the overall account value is also lower. That $100 weekly addition becomes less and less meaningful.
What you want is increasing prices, even if it means you buy fewer shares. What you're after is greater value, and that only comes with an increasing price of the shares of the fund. If the value isn't increasing, there may be no need to hold on to the investment. Or perhaps you start looking for an alternative choice for your investment dollars.
Yes, dollar cost averaging is a sound principal, especially in the beginning, but don't be lulled into ignoring its diminishing impact over time.
Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. "Our mission is to help our clients discover, design and live the life that they want to live by matching their finances with their visions, values and goals."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.