Dollar cost averaging is a term that has been around for many years, but always seems to get a lot more usage during turbulent markets. Whether it’s justification for continuing to invest in your 401K or simply systematically contributing new investable money into your accounts over a specified time period, dollar cost averaging is here to stay.
The term is rooted in algebra, and is merely a way of calculating your total average cost in an investment. Let’s face it, with investing, the general theory is to buy low and to sell high. But how many people are comfortable deploying their entire investment plan in one lump sum, especially when markets are at an elevated level? Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities.
Here’s how it works. Let’s say that you invest $200 per month into a systematic investment plan. When you made your investment last month, imagine that the price of the investment was $10 per share. As a result, you purchased 20 shares of that investment with your $200. Over the month, the value of that investment declined by 20%. Naturally, you’re a little upset. But as with most systematic investment plans, the $200 again comes out of your account, and you now have bought another $200 worth of that investment. But this time, with the share price at $8 due to the 20% decline, you actually acquired 25 shares instead of the 20 you got last month.
The end result of the two months of purchases now has you holding 45 shares for a total cost of $400. That brings your average cost per share down to a little under $9 per share. You calculate this by taking your total investment of $400 and divide it by the number of shares you hold, 45. So now if the share price goes back to your original purchase price of $10, you will have a gain of over $1 per share on your total holdings in this investment.
Of course, the theory of dollar cost averaging sounds great as long as the investment eventually starts to go up. But as we all know, past performance is no guarantee of future results. And because of that, it’s not a wise idea to blindly just keep sending money towards an investment unless you are completely comfortable in the fundamental attributes of that investment and you believe that it’s a good place to be investing money.
When dollar cost averaging, don’t think of it as a rescue plan. Take it for what it is. You are sending new money towards an investment vehicle. What you originally paid for an investment doesn’t really matter. And when it comes to future investments, only send new money towards an existing investment if you have confidence that other reasonable, informed investors would be making the same choice. And of course, that doesn’t guarantee anything!
To determine whether your existing investments merit additional investment dollars is an entirely new topic. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets. For this one you’ll need to do some research on your own or hire a competent investment advisor for some professional guidance.
John P. Napolitano is CEO of U.S. Wealth Management in Braintree and 2013 president of the Financial Planning Association of Massachusetts. Read more of his columns. Reach him at email@example.com or on Linked In. Leave a comment at the end of the column.