| Dollar-Cost Averaging |
| Even if you're new to the investment game, you've probably heard the term "dollar-cost averaging." While it may sound like some complicated accounting procedure, it's actually a very simple method of investing--one that can often reduce the volatility of your portfolio, and, in some cases, increase your returns. |
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| Don't Forget the Can Opener: | We'll start out with a simple example, though one that is still relevant to the investment process. Let's assume that you have a straightforward retirement goal. A distant relative has left you a tropical island. Your plan is to move there, where you will spend your days frolicking in the surf and subsist on a diet of fresh coconuts and berries, supplemented by a stash of canned tuna. And not just any old tuna, you want to take the good stuff--premium chunk albacore packed in spring water. You're planning on departing for your tropical paradise in five months, and you currently have $10,000 to spend on tuna. The more cans of tuna you buy, the longer you can stay on the island. When you run out, you'll have to return to the real world and go back to work. |
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| In an average year the average stock investor earned approximately twice as much as the average bond investor. Over time, however, compounding magnifies that difference greatly. After 30 years, the difference in the final value of a $10,000 portfolio invested in stocks, versus a $10,000 portfolio invested in bonds is no longer twofold, it's closer to fivefold: |
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| Here's the dilemma: Your preferred brand of tuna is currently selling for $1.80 a can. You're pretty sure that the price will be higher five months from now, but there's also a good chance it will be substantially cheaper at some point before then. (The store hasn't had a sale for quite a while.) What should you do? You could go ahead and buy $10,000 worth today (5,556 cans), but you might end up kicking yourself if there is a major sale in the next five months. Or, you could try to time the market by waiting for a sale, but if one doesn't occur--and prices climb steadily--you'll be much worse off than if you had bought sooner. Your third choice is to dollar-cost average by following a systematic investment program: On the first day of each month, you'll trek down to the supermarket and buy $2,000 worth of tuna, regardless of the current price. |
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| Do you come out ahead? Well, that depends on what happens to tuna prices over the next five months. If prices only go up, you'll be worse off than if you had bought all of your tuna at $1.80 a can. However, if prices fluctuate up and down, you might be better off with the dollar cost averaging method. |
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