Educational Programming Video
The Value Line Mutual Fund Survey
Program 7: Dollar Cost Averaging
For the next several sessions, we'll be reviewing some mutual fund basics that every fund investor should know. The focus of this session is dollar cost averaging.
In a previous session, we touched on the fact that many fund companies allow you to automatically reinvest any distributions that a fund makes to you. The value of this is that your dividends and capital gains go right back into the fund and are instantly working for you. Over time, you will accumulate a larger stake in the fund.
Fund companies, however, go one step further, allowing investors to systematically invest more money each month. These plans often referred to as automatic investment plans, allow the investor to link his or her bank or checking account with a fund. You can even set up direct deposit with some companies whereby a set amount of money will be deducted right from your paycheck and deposited with the fund each month. That pre-set amount of money is then added to your fund account, and shares equal to that dollar amount are purchased. Of course, investors don't have to have preset plans to invest more money in a fund, but using this type of service makes the process "invisible." You set it up one time, and it keeps going until you stop it.
Both of these options tap into what is known as dollar cost averaging. Basically, this means buying additional shares of a fund on a regular basis. Not such a big deal on the surface, but the ramifications are immense.
If you buy shares of a fund every month, you will be continually adding to your savings. This is a good thing, because building a nest egg is easier if you save small amounts over long periods of time.
Every purchase, however, will be at a different price. Thus, when the NAV or price of the mutual fund is high, you will buy fewer shares, and, when the price of the fund is low, you will buy more shares. Although on the surface this looks like an accounting headache, using the average cost basis makes this a non-issue. Basically an average cost basis is derived by adding up the total cost of all of the shares you own, including any commissions, and dividing that by the number of shares. (Your other option is to report the purchase and sale price of each individual share you buy-a nightmare if you add shares on a regular basis.)
So you buy more when prices are low, and fewer when prices are high, so what?
Let's take a look at an example to help explain what happens. Say you invest $2,000 in a fund with a price of $10. Great, you just bought 200 shares. One month later, you add another $2,000taken directly from your bank account of courseonly, this time, the price of the fund is $11. Because of the higher price you buy less shares, 181.8 to be exact (remember that open-end mutual funds are bought and sold in dollar amounts, not share amounts). The next month, you add another $2,000, but there was a sell off in the market and now the NAV of your fund is $7. The lower price allows you to buy 285.7 shares. Another month passes, and another $2,000 is invested automatically, this time at $8 a share. You wind up buying 250 shares. The fifth month passes, the market has rebounded, and you invest another $2,000 automatically. With the shares back up to $11, you add 181.8 shares to your account.
So, what does your account look like? For starters, you have 1,099.3 shares. The total price you paid for those shares is $10,000, five months times $2,000 a month. To figure out the average price of those shares, we divide the $10,000 by 1,099.3 (the total number of shares you purchased). So, your cost basis (the average price paid) is $9.10.
The fund's return during that five-month period was 10% ($11 minus $10 dollars, or $1, divided by $10), but your return was over 20% ($11 minus your cost basis of $9.10, or $1.90, divided by $9.10).
Wow! Just by sticking in there with a regular investment plan, you doubled your return. Of course this was just an example, but imagine the power of dollar cost averaging if you were investing for 5, 10, or 20 years.
In short, dollar cost averaging has a number of advantages: It forces you to save and invest on a regular basis and the systematic nature allows you to add more when your fund is down, and less when your fund is up, ultimately giving you the opportunity to enhance your overall return.