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From: T. Rowe Price, How it works
Time: 8:43:42 AM
Although our previous article was a definative work relative to the subject of "Dollar Cost Averaging" we feel that for some, we never totally explained what the constitutes the term. We found this great article by T. Rowe Price, The Mutual Fund people that is as good a primer as were have ever found. We thing you will find it interesting and informative as well. Robert A. Spira
Dollar Cost Averaging How It Works Getting Started
Like the pendulum that swings relentlessly back and forth, investor sentiment tends to alternate between periods of enthusiasm and despair. Unfortunately, many investors are guided by their emotions and allow the mood of the market to dominate their investment decisions.
Throughout his investment career, Thomas Rowe Price believed that no one could consistently predict the peaks and valleys of the stock market. "History and experience have proven that correctly predicting the timing and extent of stock market trends is impossible," he wrote, "because world developments and the psychological reactions of people are unpredictable." Nevertheless, numerous market timing advisory services and a myriad of investment theories attempt to guide investors through the shifting tides of financial markets. It's no surprise that a foolproof winning formula remains elusive.
One effective strategy for overcoming the emotional hazards of investing is dollar cost averaginginvesting equal dollar amounts at regular intervals, usually monthly or quarterly. This approach imposes a discipline that relieves the investor of grappling with uncertainty and volatility in the securities markets.
How It Works
The essence of dollar cost averaging is that more shares are automatically purchased when the price is low and fewer shares when the price is high. Here's a purely hypothetical example in which $200 is invested each month for a year. The investor could be purchasing shares of an individual stock or shares in a stock or bond mutual fund. (The variation among share prices shown here is more typical of stocks than bonds, however.)
This chart is for illustrative purposes only and does not represent an investment in any T. Rowe Price fund. Past performance cannot guarantee future results. Dollar Cost Averaging At Work: A Hypothetical Example Monthly Investment Price Per Share Number of Shares Purchased* January $200 $10 20.00 February $200 $11 18.18 March $200 $12 16.67 April $200 $14 14.29 May $200 $11 18.18 June $200 $10 20.00 July $200 $9 22.22 August $200 $9 22.22 September $200 $8 25.00 October $200 $6 33.33 November $200 $8 25.00 December $200 $10 20.00
Total Invested: $2,400 Total Shares Purchased: 255.09 Investor's Average Cost Per Share: $2,400 / 255.09 = $9.41 Investor's Year-End Account Value: 255.09 x $10.00 = $2,550.90 * Rounded to two decimals.
By investing steadily, the investor avoided the temptation of selling out after a few months to realize a capital gain, thereby incurring a capital gains tax liability, and also resisted the even stronger temptation to sell when the price dropped, possibly incurring a loss. Notice that more shares were acquired when the share price fell and fewer as it rose. The investor's average cost per share, $9.41, is below the purchase price in seven months.
Of course, the ideal course of action would have been to invest the entire $2,400 at the year's low of $6, but that would have required either a first-class crystal ball or a good deal of luck. Few, if any, investors can hit the lows successfully on a regular basis. Likewise, dollar cost averaging saved the investor from the bad luck of investing all the money at the year's high of $14, a situation more of us are familiar with than we would like to admit.
Let's look at another example using the Standard & Poor's 500 Stock Index, a broad-based common stock index that is widely accepted as a market benchmark. In 1987, investors went on a wild ride, as the market rose to new highs only to crash on "Black Monday" in October. Actually, prices fell on balance from August through November, as you can see in the following table. Understandably, many investors sold stocks as prices plummeted, but hindsight shows that this was an idealbut emotionally difficulttime to buy.
This chart is for illustrative purposes only and does not indicate future results for a specific investment. Example: Dollar Cost Averaging During 1987 Investment Amount S&P 500 Price Shares Purchased Total Market Value January $200 $274.08 0.7297 $ 200.00 February $200 $284.20 0.7037 $ 407.37 March $200 $291.70 0.6856 $ 618.11 April $200 $288.36 0.6936 $ 811.04 May $200 $290.10 0.6894 $1,015.93 June $200 $304.00 0.6579 $1,264.61 July $200 $318.66 0.6276 $1,525.58 August $200 $329.80 0.6064 $1,778.91 September $200 $321.83 0.6214 $1,935.90 October $200 $251.79 0.7943 $1,714.59 November $200 $230.30 0.8684 $1,768.24 December $200 $247.08 0.8095 $2,097.09 Total Invested: $2,400 Total Shares Purchased: 8.4875 Investor's Average Cost Per Share: $2,400/8.4875 = $282.77 Investor's Year-end Account Value: $2,097.09
By dollar cost averaging during 1987, an investor would not have avoided a principal loss for the year. However, the investor would have avoided two traps: first, the possibility of committing the entire $2,400 during the euphoric atmosphere of the eight months that preceded the October crash; and, second, the temptation to cash out at the bottom. By dollar cost averaging, the investor would have continued to accumulate shares and participate in the market's ascent to new highs in subsequent years.
If you are investing in mutual funds and reinvest your dividend distributions, you are already using the principle of dollar cost averagingyour dividends will purchase more shares when the fund's price is lower and fewer shares when the price is higher. If you buy individual stocks, you can apply this principle by taking advantage of dividend reinvestment programs offered by many corporations. However, the reinvestment of stock dividends and mutual fund distributions is not a perfect example of dollar cost averaging, since the amounts you receive will probably vary.
To invest a specific amount of money on a regular basis, you may want to consider systematic investment programs offered by many mutual fund companies. These programs can make automatic investments in a fund at fixed intervals by transferring money electronically from your checking account or, in some cases, your paycheck or a money market fund. You select the amount of money to be automatically invested, the time interval, and, of course, the mutual fund. This way, you don't have to remember to do it, and you don't have to exercise the discipline of setting aside the money for investing.
Of course, dollar cost averaging does not assure a profit or protect you against a loss in declining markets. Also, since the program's benefits are realized over time, you should be prepared to stay the course during periods of low prices as well as high.
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