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The Virtues of Dollar-Cost Averaging


Consistency Pays



by Virginia B. Morris

If the biggest stumbling blocks to building your investment accounts are deciding what to buy and believing you don’t have enough money on hand, you might want to consider a convenient, simple strategy called dollar-cost averaging.

   


With dollar-cost averaging — sometimes abbreviated as DCA and other times called a constant dollar plan — you invest the same amount of money in the same stocks or mutual funds regularly, such as biweekly, monthly or quarterly.  In fact, if you’re contributing to a 401(k), 403(b), thrift savings or similar employer plan, you’re already using dollar-cost averaging.  For example, assume you defer $200 each pay period and split it evenly among four investments in your employer’s plan.  If you’re paid biweekly, you’re adding $50 to each fund every two weeks.

Because stock and mutual fund prices fluctuate regularly, the number of shares you buy when investing this way varies.  When prices are up, your regular installment purchase buys fewer shares, and when prices are down, that same amount buys more shares.

More Than a DRIP in the Bucket

The simplest and most cost-effective way to buy stock using dollar-cost averaging is to enroll in the dividend reinvestment plan of a holding in your portfolio.  When the company reinvests your dividends, typically each quarter, it sends a reminder that you can buy additional shares.  DRIPs typically set a minimum of $100 per transaction and may limit the number of transactions per year.  (Editor’s note:  For a partial list of companies with direct purchase plans, go to http://www.betterinvesting.org/Members
/Investing/Stocks/Resources/DRIPs/default.htm
)

With no-load mutual funds, you can open an account by buying shares in a fund and then make regular additional purchases.  And although you can’t make incremental investments in bonds, you can employ dollar-cost averaging in bond mutual funds. 

Minimum investment requirements are also modest with mutual funds.  Some fund companies let you commit as little as $50 per purchase — though a $100 minimum is more typical — if you enroll in a direct investment plan.  This way, money is transferred electronically from your checking account to the funds on a particular day each month.

Of course, you can also buy stocks and funds on a regular schedule through your brokerage account.  This method may not be ideal, however, since the sales charges can take a substantial bite out of the limited amount you’re investing.

Dollar-cost averaging is also a convenient way to build your IRA or Coverdell Education Savings Account without scrambling to make your annual contribution as the deadline approaches.  But you do have to keep track of what you’re putting in so that the total doesn’t exceed the annual contribution limits. 

For 2007, these limits are $4,000 for an IRA and $2,000 for an ESA.  For 2008, it’s $5,000 for an IRA and $2,000 for an ESA.  If you’re 50 or older, you can also make IRA catch-up contributions of $1,000 each year.

Better Than Average

Although the primary benefit of dollar-cost averaging is from investing regularly, there’s another major advantage.  If you stick to your plan — say, investing $500 each quarter in additional shares, over and above any reinvested dividends — you may be able to lower the cost of investing.  That’s because the average price you pay per share using dollar-cost averaging is lower than the average cost of the shares over the same period.

But to achieve these savings — which can help boost your account value over time — you must buy when prices are dropping as well as when they’re trending up.  If you’re reluctant to invest when the market is falling and stop putting money in regularly, you’ll actually defeat a key element of this strategy, which is to lower overall cost by averaging high prices for a smaller number of shares and lower prices for a larger number of shares.

In a very simplified example, let’s assume you invested $100 a month.  In the first 11 months of the year, the price of a stock was $20 in six of the months and $25 in five of them.  You’d end up with 50 shares (30 at $20 per share and 20 at $25 per share).  Your average cost would be $22 a share ($1,100 ÷ 50 = $22). 

But suppose in the next month the price dropped to $10.  If you invested another $100, you’d receive 10 more shares for a total of 60.  Your average cost would be $20 a share ($1,200 ÷ 60 = $20).

One potential drawback of dollar-cost averaging is that you’re surrendering the possibility of investing a large sum in a stock just when its price is at a low point.  By buying at the low point, you would end up with more shares than by paying the average price over time. 

But you must weigh this possibility against the reality that pinpointing the bottom is virtually impossible.  In addition, you’d need to have a large sum on hand to make the sizable purchase. 

Keeping Track Over Time

One potential headache with dollar-cost averaging is calculating the capital gains taxes you might owe when you sell the investment.  To figure the tax liability, you’ll need the cost basis of shares you purchased in small increments over time.  Sometimes the corporation or fund company will provide the information you need.  But if you’ve been using this strategy for a long time, the records may be hard to reconstruct.  One solution is to keep your end-of-year statements for as long as you own an investment so that you have a record of what you paid for each group of shares. 

These record-keeping requirements aside, the bottom line is that dollar-cost averaging is convenient and has proven an effective investment strategy over time.  Of course, using this approach doesn’t guarantee gains or prevent losses. 

But investing regularly over the long term in a diversified portfolio is one of the surest ways to reach your financial goals.

Virginia B. Morris is the Editorial Director for Lightbulb Press.




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