Wednesday, March 07, 2007

Investing tip: Dollar Cost Averaging

This is the best investment tip that you should definitely use and share with others when it comes to investing. Dollar Cost Averaging (DCA) is where you invest the same amount of money on a regular schedule, regardless of the price per share. My economic classes talk briefly about this concept but I was never able to see what good this concept is going to do for me. All they tested me on was to calculate some numbers or fill in the missing numbers.

But if you are an investor, you should pay careful attention on what I'm going to show you. Most clients I sit down with have $100 or more to save each month. They don't realize it, but they actually do when I do a budget worksheet for them. So, let’s say you invest $100/month.

MONTH 1, Price per share is $25, so you bought 4 shares.
MONTH 2, Price per share is $20, so you bought 5 shares.
MONTH 3, Price per share is $15, so you bought 6.67 shares.
MONTH 4, Price per share is $10, so you bought 10 shares.
MONTH 5, Price per share is $15, so you bought 6.67 shares.
MONTH 6, Price per share is $25, so you bought 4 shares.

Total shares you own by end of Month 6 will be: 36.34 shares.
The average price per share was ($25 + $20 + $15 + $10 + $15 + $20) divided by 6 is: $17.50
The average cost per share was ($600 divided by 36.34) is: $16.51. You just reduce your cost per share by almost $1 in a 6 month period!

If you were to invest the full $600 in the first month, you will have 24 shares with price per share is $25. With DCA you would of bought almost 12 more shares and reduce your cost per share by $7.50.

Dollar Cost Averaging doesn’t ensure you profits or protect you from short-term or long-term risks, but it does make you a disciplined investor. Most investors in the market don’t know how to invest. They pull out when the market crashes and then come back in when the market does well. There are three things an investor is concern with:
1) Risks, which is the potential that you can lose money,
2) Return, which is the potential you can earn money, and
3) Volatility, which is the day to day fluctuations.

Let’s say you pull out of the market in month 3 with a total of 15.67 shares at $15/share. You will get $235.05 check. Then you come back in Month 6 where price per share is $25 and you put the $235.05 back in the market, so you will now own 9.402 shares. You now own less shares and paying a higher cost per share too. So in reality, you are worse off. This is how many people invest their money and it’s a stupid investment strategy.

If you invested $1000 and you did nothing, you are not accepting any risks or return until you sell them. It’s really a mind-game and even the most discipline investors will be tempted to pull out the market when the stock market crashes. All I have to say if you are investing in the long run, keep where your money is and stay on course.