Dollar-cost averaging (DCA) is a wealth-building strategy that involves investing a fixed amount of money at regular intervals over a long period. This type of systematic investment program may be familiar to investors with 401(k) and 403(b) retirement plans. The concept is the same: Every paycheck adds the same amount to your retirement account whether the market is going up or down.
When it comes to implementing investment strategies based on dollar-cost averaging, there may be no better investment vehicle than the no-load mutual fund. The structure of these mutual funds almost seems to have been designed with dollar-cost averaging in mind. Let's look at why this is so, and explore how dollar-cost averaging is employed when investing in mutual funds.
Review of Dollar-Cost Averaging
Dollar-cost averaging is carried out simply by investing a fixed dollar amount into your mutual fund (or other investment instruments) at pre-determined intervals. Most investors use brokers geared towards day trading to make these investments, and some have features that allow you set up automatic investments. The amount of money invested at each interval remains the same over time, but the number of shares purchased varies based on the market value of the shares at the time of purchase. When the markets are up, you buy fewer shares per dollar invested, due to the higher cost per share. When the markets are down, the situation is reversed, and you purchase more shares per dollar invested. It's a strategic way to invest, as you buy more shares when the cost is low, so you get an average cost per share over time, meaning you don't have to invest the time and effort to monitor market movements and strategically time your investments. The real value of dollar-cost averaging is that investors don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market.
Dollar-Cost Averaging Example
For example, assume an investor invests $1,000 on the first of each month into Mutual Fund XYZ. Assume that over a period of five months, the share price of Mutual Fund XYZ at the beginning of each month was as follows:
• Month 1: $20
• Month 2: $16
• Month 3: $12
• Month 4: $17
• Month 5: $23
On the first of each month, by investing $1,000, the investor can buy a number of shares equal to $1,000 divided by the share price. In this example, the number of shares purchased each month is equal to:
• Month 1 shares = $1,000 / $20 = 50
• Month 2 shares = $1,000 / $16 = 62.5
• Month 3 shares = $1,000 / $12 = 83.33
• Month 4 shares = $1,000 / $17 = 58.82
• Month 5 shares = $1,000 / $23 = 43.48
Regardless of how many shares the $1,000 monthly investment purchased, the total number of shares the investor owns is 298.14, and the average price paid for each of those shares is $16.77. Considering the current price of the shares is $23, this means an original investment of $5,000 has turned into $6,857.11.
If the investor had spent the entire $5,000 on one of these days instead of spreading the investment across five months, the total profitability of the position would be higher or lower than $6,857.11 depending on the month chosen for the investment. However, no one can time the market. DCA is a safe strategy to ensure an average price per share that is favorable overall.
Why Dollar-Cost Averaging Works Well With Mutual Funds
The expense ratio that mutual fund investors pay to invest in a fund is a fixed percentage of your contribution. That percentage takes the same relative bite out of a $25 investment or regular installment amount as it would out of a $250 or $2,500 lump-sum investment. Compared to, say, stock trades, where a flat commission is charged on each transaction, the value of the fixed-percentage expense ratio is startlingly clear. Consider the following:
- By making a $25 installment in a mutual fund that charges a 20 basis-point expense ratio, you pay $0.05, which amounts to a 0.2% fee.
- By making a $250 lump-sum investment in the same fund, you pay $0.50, or a 0.2% fee.
- By making a $25 investment in a typical stock through a broker who charges $10 commission per trade, you pay $10, which amounts to a 40% fee.
- By making a $250 investment in a typical stock through a broker who charges $10 commission per trade, you pay $10.00, which amounts to a 4% fee.
The examples above show that you have to buy more stock in order for the percentage of the commissions to go down. In comparison, the structure of the mutual fund expense ratio makes the investment more accessible: the no-commission trading of the mutual fund, coupled with low minimum investment requirements, allows almost everyone to afford mutual funds.
Furthermore, many mutual funds waive their required minimums for investors who set up automatic contribution plans (plans that put dollar-cost averaging into action). All this enables low-wage earners and folks with tight budgets to invest $10 or $25 or another nominal amount on a regular basis without worrying about the impact of trading costs. While small contributions may not seem impressive at first glance, they enable investors to get into the habit of saving, and can really add up over the course of a lifetime thanks to the power of compounding.
Of course, dollar-cost averaging with mutual funds isn't a strategy whose usefulness is greatest for the less than affluent. If you have a large sum of money and invest it all at once, you face the risk that declining financial markets will take a huge chunk out of your portfolio. Dollar-cost averaging offers the perfect solution to your dilemma. To facilitate a long-term strategy for investing large sums of money, many mutual funds offer investors the ability to make a lump-sum investment in a money market fund, from which predetermined amounts are automatically invested into a designated higher-risk mutual fund at pre-arranged intervals. It's a convenient, cost-efficient solution that mitigates concerns about investing a large amount at the wrong time.
A Long-Term Strategy
Regardless of the sum you have to invest, dollar-cost averaging is a long-term strategy. While the financial markets are in a constant state of flux, over long periods of time they tend to move in the same general direction. Bear markets and bull markets can last for months, if not years. Because of these trends, dollar-cost averaging is generally not a particularly valuable short-term strategy.
For example, consider an investor making 10 purchases of a mutual fund's shares over the course of a month. While the purchase price of the shares will not likely be identical for each transaction, it is also unlikely that they will differ significantly over such a short time frame.
On the other hand, over the course of a market cycle lasting five or 10 years and including a bull and a bear market, the price of a given security is likely to change significantly. Dollar-cost averaging will help to ensure that your average cost per share represents both the premiums of a bull market and the discounts of a bear market, as opposed to just the premiums usually paid by investors in a bull market.
Keep Costs in Mind
While low, percentage-based expense ratios make mutual funds the perfect vehicle for dollar-cost averaging, it pays to exercise caution when it comes to your investments. Some mutual funds charge low-balance fees, sales loads, purchase fees, and/or exchanges fees. Be sure to read the disclosure materials prior to investing, and make sure you are aware of all the expenses associated with your investments.