Dollar-Cost Averaging: my path to becoming a not-so-nervous investor
Can the concept of dollar-cost averaging (DCA) help prevent nervousness in investors? (I think so.) But what is DCA and is it a viable investment strategy? If you are a seasoned investor with a large lump sum from a 401(k) rollover, property sale, inheritance, or other source, you are likely to think of DCA as second-rate or lower-performing strategy, which it in fact may be. But if you are a beginning or less experienced investor who has just a bit to invest each month ($25 to $100), then the DCA concept may help you feel comfortable in starting to invest and let you relax during market fluctuations.
Here’s a short definition of dollar-cost averaging from Kiplinger’s glossary: “a program of investing a set amount on a regular schedule regardless of the price of the shares at the time.”
As an illustration, suppose you decided to buy Janus Venture (JAVTX, a no-load, small cap growth mutual fund with a 4-star Morningstar rating considered high risk with above average returns) in September 2006, invest $100 per month for 13 consecutive months (Sep 2006-Sep 2007), and purchase shares sometime around the 20th of each month. I used MSN Money charts to find prices on specific dates in the past year.
By September 2007, you’ll have invested $1,300, purchased 19.46 shares at an average cost of $66.79, and have an investment valued at $1393; you'll have earned a return of 7.15% for this period. But, if you had invested $1,300 as a lump sum in September 2006, you would now have $1,549 and grown your investment by 19.15%. In this scenario, the DCA strategy is the lower-performing one. But, I am proposing that if you are a beginning investor and you did not have $1,300 in September 2006 but rather $100/month in investable income, then you are $1393 richer and now positioned for further growth (hopefully). Here's a spreadsheet with the monthly prices and my calculations.
It is argued, and convincingly to me now that I consider it, that DCA as a strategy for lump-sum investing is almost always not the best strategy because the market in general and individual investments in particular (no-load mutual funds in this case) rise over time. So, more often than not, the sooner you can make an investment, the better. In "The costly myth of dollar-cost averaging," Timothy Middleton of MSN Money states that dollar-cost averaging is not the same as investing regularly scheduled amounts but rather positions it as an alternative to investing a lump-sum amount. He mentions that this strategy is often pitched to nervous investors. If you define DCA as an alternative to lump-sum investing as Wikipedia does, consistent with Mr. Middleton's perspective, then DCA is usually going to deliver lower-performing results. Oddly, though, I had only heard of DCA in my finance classes in college and have never been pitched its value by investment salespersons (maybe I'm not a nervous investor).
Trent of The Simple Dollar writes about Dollar-Cost Averaging and uses a definition similar to Kiplinger.com and my understanding: "Dollar cost averaging is an investment philosophy in which you buy a particular investment regularly over a period of time with an equal amount of cash each time."
As for me and my portfolio, I didn’t start investing as a lump-sum holder but rather as an eager 20-something who, when I was able to start saving, figured that investing, over time, even small amounts, would reap benefits. My strategy wasn’t particularly sophisticated (just disciplined), beginning with a dividend reinvestment plan (DRIP), progressing to purchases of mutual funds, and then, much later, to individual stock investing. In my DRIP-and-mutual-funds-only days, shares were purchased when the prices were low and high. Here's what I learned:
- Prices go up and down;
- Sometimes you buy shares at attractive prices and sometimes you buy shares at not-so-attractive prices;
- The value of your investments may decline during market corrections or investment-specific slumps;
- Over time, the value of sound investments will rise.
So, DCA helped me get used to the idea that investing doesn't always provide a smooth ride but can deliver great returns in the long run. It's saved me from becoming a nervous investor (or at least one who doesn’t act rashly and sell during market lows) despite day-to-day fluctuations in my net worth.
Disclosure: I do not own Janus Venture, which is closed to new investors.