Dollar cost averaging is an investment strategy that allows investors to take advantage of various fluctuations in the market without having to actively time the market. Setting up this type of strategy is fairly simple, and generally only requires that an investor set up a reoccurring (consistent) automatic deposit into their investment account or portfolio from their checking or savings account. For example, an investor looking to deploy this strategy would set up an automatic deposit of $1,000 into their investment account on the first of every month for five years.
The basic premise of dollar cost averaging is that by setting a fixed dollar amount to buy securities on a regular basis (i.e. monthly, bi-monthly, quarterly, etc.) you are buying securities at both highs and lows in the market and, on average, receiving a favorable price. This is because you are buying more shares when the share price or net asset value is lower and less shares when the share price or net asset value is high. The ideal result is that you would receive a lower share price on average than if you were to invest a lump sum all at once in an attempt to time the market.
To illustrate the advantages of dollar cost averaging, we are going to employ the use of a hypothetical portfolio that is made up of shares of a single exchange traded fund (ETF), with the ticker symbol “SPY”, (one of the first exchange traded funds ever created which tracks the S&P 500). We are also going to use a hypothetical investor that has set up a monthly transfer of $1,000 from her checking account into her investment account. Below, we have listed the real market data to show how the net asset value (NAV) of SPY fluctuated over the last six months:
September 1st, 2017 NAV of SPY: $247.97 October 1st, 2017 NAV of SPY: $252.27 November 1st, 2017 NAV of SPY: $257.54 December 1st, 2017 NAV of SPY: $264.46 January 1st, 2018 NAV of SPY: $268.77 February 1st, 2018 NAV of SPY: $281.90
If our hypothetical investor, invested her $1,000 on the first of each month, over the last six months, the average price she would have paid is $262.15. As of Feb. 6th, 2018, the day this article was written, the NAV of SPY is $269.06. In this example, the investor ended up paying a lower price on average for shares of SPY than the current NAV. However, as with all things in the marketplace, nothing is guaranteed, and some years investors may realize a higher cost on average for a certain security and some years investors may realize a lower cost on average for a certain security.
The beauty of dollar cost averaging is that our investor did not have to try and time the market in order to take advantage of market volatility. She simply set up the automatic transfer and let her bank, her investment advisor, and the market do the work for her. Another inherent benefit of dollar cost averaging as an investment strategy is that it can help you save money and prepare for retirement by automatically investing excess cash instead of having it sit in your account, tempting you to spend it. Whether you are a millennial, member of Generation X, or baby boomer, saving money every month can be difficult. Especially when there are so many temptations in today’s highly connected world. By setting up automatic deposits every month when you receive your pay check or salary, you never actually “see” the money in your checking account, it just goes straight into your investment account. This can be very helpful for beginning investors by making saving and investing a more painless process.