30 July 2007 One Comment Print This Post  Email This Post

Last week, I finally got around to opening a Roth IRA. A few days went by before my first trade was confirmed as I had to move money over from my traditional bank account. The purchase finally went through on Friday July 26th, and the purchase was for $4000 worth of E-trade’s low cost S&P 500 index fund, symbol ETSPX. As some of you may know, the market took a hit on that day and so far I’m down 1.53% which is about $60.

That got me thinking about stock market fluctuations and how the everyday investor would react to them. I think a lot of novice or young investors like myself and risk adverse people will lose confidence in the system, and therefore be discouraged to invest any further. Some may even go as far as selling off their remaining shares, taking the loss and getting out all together never to return. What most common investors don’t know about and practice is the power of dollar cost averaging, which is something I should have done for my $4000 initial investment in my Roth IRA account.

What is Dollar Cost Averaging (DCA)?

Dollar cost averaging is a technique used to reduce market risk by spreading your investments into smaller chunks at various times rather than investing a lump sum at one time. For my particular situation, the amount invested is limited by the US government at $4000 for 2007. Had I invested $1000 a month for the next four months instead of the whole $4000, I may have a larger total return on investment. The reason for this is because the stock market goes up and down all the time like how certain items go on sale at your local supermarket. Let’s say your neighbor buys $500 worth of meat every month at the supermarket, which he freezes and use over time. You however, go to the supermarket five times a month and buy $100 at a time. Two of the times, the meat goes on sale and you pay $70 instead of $100. After that month, your neighbor paid $500 while you only paid $440. The point of dollar cost averaging is that sometimes stocks go on sale and your chances of buying them on sale increases when you spread out your investment.

A Real Life Stock Example

Lets say you had $10,000 to invest in January 2002. You buy 1114.83 shares of ETSPX at $8.97 a share. We are excluding fees for the sake of this example. On January 2004, two years later ETSPX closes at $9 a share and your investment is worth $10,033.47! You’re up a whopping $33.47. Had you utilized dollar cost averaging, you would have divided the $10,000 into 24 equal months of investing, which is $416.66 a month. If you have done that, on January 2004 you would own 1345.02 shares of this fund and it will be worth $12,105.22. Take a look at the excel sheet I created below showing the various months where you were able to buy the shares “on sale” at under $8 and even under $7.

Another Advantage

There is another advantage for those who have a lump sum of money ready to invest, such as the $10,000 in the example above. While you are practicing dollar cost averaging, you can invest the rest of the money into more conservative vehicles such as certificates of deposit or even an e-savings account, so you earn 4-6% on that money just about risk-free that is waiting to be invested into the stock market.

Conclusion

The power of dollar cost averaging is real. Maybe I should have done it but I was in the “set it and forget it” mode when I made the trade keeping in mind it is a very long term investment. The fact of the matter is that we know for certain that the stock market does fluctuate, so by utilizing dollar cost averaging you are increasing your chances of buying stocks “on sale”, and decreasing your chances of a catastrophic loss. Go set up your DCA plan and stick to it like white on rice.