Quick question: When you see the words, “dollar-cost averaging,” do your eyes immediately glaze over? Or, do you picture in your mind some complex formula that requires a master’s degree in mathematics to understand?
Well, if you answered “yes” to either of these questions, then please relax.
The concept behind dollar-cost averaging is pretty straightforward, and here’s how it works: Simply set aside some money to invest on a regular basis, such as through automatic payroll deductions from your employer or the automatic investing service from your mutual fund company, and invest the same amount every time.
And that’s all there really is to it.
So, in order to see this formula in action, let’s say you put $100 every month into a mutual fund with a price that changes at the end of every business day. And in the following example, you’ll see how the up and down swings in the fund price actually work in your favor.
Again, the table below shows four monthly investments of $100, each of which are made at four different prices. Notice that when the price is higher, you buy fewer shares. And when it’s lower, your $100 stretches even further and buys more shares for you.
And best of all, this happens automatically, with no thought or effort needed from you.
| June | July | August | September | |
| You Invest | $100 | $100 | $100 | $100 |
| Mutual Fund Price | $21 | $15 | $17 | $23 |
| Number of Shares You Buy | 4.76 | 6.67 | 5.88 | 4.35 |
| Total Number of Shares You Own | 4.76 | 11.43 | 17.31 | 21.66 |
| Total Investment | $100 | $200 | $300 | $400 |
| Cost Per Share | $21 | $17.50 | $17.33 | $18.47 |
| Average of All Mutual Fund Prices | $21 | $18 | $17.67 | $19 |
As you can see from the bottom right-hand part of the table, you paid $18.47 for each share that you now own. But that’s slightly lower than $19, which is the average of all four of the fund prices which you purchased from.
One thing to keep in mind, however, is that dollar-cost averaging won’t guarantee that you make a profit. But at the same time, though, it will guarantee that the cost of all the shares you own will be lower than the average of all the prices you pay.
Now, at this point, perhaps you’re thinking, “So what? Is that really a big deal?” Well, if that’s the case, then here’s a real-life example that shows why all of this can actually matter.
For the stocks that are included in the S&P 500 Index, which is a benchmark that measures the performance of the largest companies in the U.S., the 10-year period from 2000 to 2009 could’ve been a pretty painful time for investors.
For instance, let’s say you owned the Vanguard 500 Index Fund Investor Shares (ticker symbol “VFINX”), which is a fund that seeks to track the performance of the S&P 500 Index. If you invested $10,000 in the fund that at the start of 2000 and did nothing else, by the end of 2009, you would’ve had just $9,016. In other words, you would’ve lost $984, and your loss would’ve been 9.8%.
Here’s how your money would’ve dwindled in value:
| Year | Value of $10,000 invested at the start of 2000 |
| 2000 | $9,094 |
| 2001 | $8,001 |
| 2002 | $6,229 |
| 2003 | $8,004 |
| 2004 | $8,863 |
| 2005 | $9,286 |
| 2006 | $10,739 |
| 2007 | $11,317 |
| 2008 | $7,128 |
| 2009 | $9,016 |
On the flip side, if you used dollar-cost averaging and invested $1,000 at the start of each of those 10 years, you would’ve ended up with a profit after 2009. Instead of losing $984, you would’ve made $483.
Here’s how your money would’ve grown in value:
| Year | Value of $1,000 invested at the start of each year |
| 2000 | $909 |
| 2001 | $1,680 |
| 2002 | $2,086 |
| 2003 | $3,966 |
| 2004 | $5,499 |
| 2005 | $6,809 |
| 2006 | $9,031 |
| 2007 | $10,571 |
| 2008 | $7,288 |
| 2009 | $10,483 |
“Why was there such a wide swing in the ending final values?” you ask. Well, the reason for the difference is because there were wild ups and downs in the annual growth rates of the stocks in the S&P 500 Index.
This made it unlikely that some timid investors would keep calmly investing year after year. But for those committed investors who persisted, the yearly losses provided golden opportunities to acquire assets inexpensively.
To be more specific, the table below shows how the Vanguard 500 Index Fund Investor Shares performed over the period:
| Year | Growth Rate |
| 2000 | -9.06% |
| 2001 | -12.02% |
| 2002 | -22.15% |
| 2003 | 28.50% |
| 2004 | 10.74% |
| 2005 | 4.77% |
| 2006 | 15.64% |
| 2007 | 5.39% |
| 2008 | -37.02% |
| 2009 | 26.49% |
As you can see, all of the low-priced shares that were available after the declines from 2000 to 2002 and 2008 were able to benefit from the returning growth of the stock market which took place from 2003 to 2007 and 2009, including four years of double-digit growth.
Now, since these are actual stock market results, this isn’t an unusual case. In fact, you might have to face a market with this much instability again in the future.
But, as we’ve seen from this example, the good news is that dollar-cost averaging, when combined with confident level of patience, can pay off nicely for you. In other words, investing consistently in a group of stocks with volatile prices can turn a losing investment into a winning one.
So, even though we can’t predict the future, we can pretty much guarantee that there will never be a fool-proof sign that tells you the perfect time has come to get into the market. And if you wait until the economy looks great and stocks seem like a sure bet, you’ll wait too long to take advantage of any bargains. But, by sticking with the dollar-cost averaging formula, you won’t miss out on your greatest opportunities to make money over the long term.