Dollar Cost Averaging with ETFs: Taking Emotion Out of the Buying Equation
Dollar cost averaging means investing a fixed amount of money on a regular basis. For example, if you invest $300 every month regardless of market conditions, you are dollar-cost averaging. The benefit is that you wind up buying more stock and reducing your cost basis. Huh? Yeah, it's a little confusing. Over time, the market trend is usually up, the S&P 500 average annual return since 1975 has been 10.75%. If you invest a fixed amount every month, especially during bear markets and corrections, you are buying stock at lower prices which allows you to buy more shares. When you combine a positive trend with buying low, you get more stock at a lower cost basis.
The reason this behavior made the list of top 10 investing principles is because most investors do the exact opposite. Don't you feel the urge to buy when the market is bullish and rising and feel the urge to wait or sell when the market is bearish and dropping? Most people do, and as a result they buy when prices are high and do nothing or sell when prices are low or falling. This kind of behavior greatly increases your cost basis and decreases your returns, so avoid it, be a dollar-cost averager.
This may be easier to understand with an example:
- Dollar-Cost Averaging: Let's say you decide to buy $300 worth of an S&P 500 index (e.g. SPY) fund per month for three months regardless of market conditions. In the first month the price is $12 so you receive 25 shares, in the second month the price is $15 so you receive 20 shares, and in the third month the price is down to $10 so you receive 30 shares. Your average cost per share is $12 ($900 invested / 75 shares owned), you bought the most at a lower price. When the index goes back to $15, you have your $900 investment plus a $225 profit for a total of $1,125.
- Typical Investor Behavior: Now we'll look at how most investors behave. You loved the index fund at $12 so you bought the same 25 shares as the dollar-cost averager, and you loved it even more at a bullish $15 so you bought the additional 20 shares. Unfortunately, when it dropped to $10, you got nervous and decided it would be best to wait and see what happens before you sink any more money into the market. Your average cost per share is $13.33 ($600 invested / 45 shares). When the index goes back to $15, you have your $900 investment plus a $75 profit for a total of $975.
The dollar-cost average earned a 25% return while the other investor only earned 8%. Remember that even if the market plunges it always recovers for long term investors, and when it is low you will snatch up a lot of shares at bargain prices. As long as you are dollar-cost averaging you will always be buying shares at a cheaper price.