Dollar Cost Averaging

In my first few blog entries, I introduced some of the basic, common principles of personal finance: keeping costs low, paying yourself first, taking advantage of compound interest, starting an emergency fund, and defining investment goals. I consider these to be the most essential concepts for any long-term financial plan.

Another commonly mentioned principle that I have not yet discussed is dollar cost averaging. This is the practice of investing a fixed dollar amount at regular (often monthly) time intervals. So, for example, if you have an annual investment goal of $5000, you would transfer $417 into your investment account on a fixed date every month, as opposed to writing one check for $5000 at the end of the year. Many consumer investment accounts, such as mutual funds, offer an option to set up these regular investment transfers for free.

The standard rationale for dollar cost averaging is that it reduces the risk of market timing on your investment return. Tradable assets (like stocks and bonds) go up and down in price daily, but if you put in the same dollar amount every month, you will automatically be buying more shares when prices are low, and fewer shares when prices are high.

Studies have shown that even sophisticated, professional money managers tend not to be very good at timing their investments ("buying low and selling high"), so why should Joe Musician expect to be any better at timing his purchases? Actually, the data is somewhat mixed regarding typical returns through dollar cost averaging as opposed to other investment schedules, but the fact that average investors should avoid the temptation to time the market is generally undisputed.

I would argue, however, that there is a more compelling reason to employ dollar cost averaging in your financial plan. It is the ultimate "pay yourself first" tool. If you know that $417 is going to be automatically deducted from your checking account on the 15th of every month, then you will view that as simply another bill to be paid and you'll be forced to budget accordingly. If, on the other hand, you put off investing and plan to just write a $5000 check at the end of the year with all of your anticipated lucrative holiday gig income, you might come up short. For this reason alone, I think dollar cost averaging is a great way to invest.