Talking Money: Dollar Cost Averaging
Joel Dresang: Isabelle, we talk about diversifying investments, not putting all of your eggs in the same basket, and one way to diversify is over time. And a way to do that is dollar cost averaging. Can you explain what that is?
Isabelle Denton: Yes. Dollar cost averaging is an investment technique where rather than adding to your investment in a few large lump sums, you add a smaller fixed-dollar amount at a fixed interval over a period of time. That interval could be weekly, monthly, quarterly or annually.
Joel: Why would you want to do that?
Isabelle: Anyone who can remember back to their first finance class knows to buy low and sell high. But it’s not always so easy for investors to know when that most opportune low-price buying opportunity is. So dollar cost averaging can help diversify away from the risk of buying when prices are too high. When you add a fixed-dollar amount at a fixed interval over time, the cost that the investor pays actually averages out to the average price per share during that time period.
Joel: So it takes the guesswork and some of the stress out of it.
Isabelle: Yes. So an example would be if an investor added $100 to a fictitious stock that mirrored the broader market every quarter from, say from 2007 to 2013, in years like 2009, the price per share would be pretty low. So with that $100, you could get more shares for your $100. Where, in contrast, in 2013, the price per share would be higher, so they would get less shares for that $100.
To foster financial literacy, the Talking Money feature covers common terms and concepts used in personal finance and investing. For more Talking Money terms, please click here.
But the main point is, over that time, the average price that they paid would be $12.09. But if you compared that to say they hadn’t set up the dollar cost averaging, and they decided in 2013 they had some money in their savings, and they wanted to add $2,600 to their account, they would risk paying that all at the higher prices and because of that, they would have less shares.
Joel: And then, so over time, with more shares, it would be of greater value.
Isabelle: Exactly. You would have more room to grow.
Joel: So it seems that dollar cost averaging then would benefit you the more time you have.
Isabelle: It’s especially helpful for young investors because it’s normally set up as an automated process. So it’s a good way for forced savings, and it helps them start accumulating wealth.
Isabelle Denton is a registered representative at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted Feb. 26, 2014)
More information and insight from Money Talk