Dollar-Cost Averaging continued...
You Can't Eat Your Mutual Fund
So far, our discussion has focused on getting the most for your money: let's talk about risk. When purchasing tuna, the only real "risk" you took was the possibility of missing out on a future sale. If you started with 5,556 cans of tuna, you could do no worse--you would always have 5,556 cans. Your only possible loss was an opportunity loss--the chance that you could get more for your money in the future. Mutual fund shares, however, are a little different. They have no intrinsic value, other than the cash you can get when you redeem them. It's as if you lost your can opener, and had to sell your cans of tuna at the current market price in order to extract any value from them. If the share price of your mutual fund declines, your investment is worth less, even though you still own the same number of shares.
In the same way that dollar-cost averaging will net you more tuna in a declining market, it can curtail your losses as the stock market goes down:
 
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    Dollar-Cost Averaging: In a Declining Market
    Month  
Share
Price
   Dollar Cost
Averaging
$2,000 buys		   Lump Sum
$10,000
buys
1 $10.00 200 shares 1,000 shares
2 $9.50 211 shares ----
3 $9.00 222 shares ----
4 $8.50 235 shares ----
5 $9.00 250 shares ----
Total 1,118 shares 1,000 shares
Ending Value $8,944 $8,000
                       
   
Either way, you lose money, but you lose less by dollar-cost averaging. And, when the market goes back up, you'll be in better shape because you own more shares of the fund. However, if the market had gone up instead of down, you would have been better off with the lump sum investment:
     
    Dollar-Cost Averaging: In a Rising Market
    Month  
Share
Price
   Dollar Cost
Averaging
$2,000 buys		   Lump Sum
$10,000
buys
1 $10.00 200 shares 1,000 shares
2 $10.25 195 shares ----
3 $10.75 186 shares ----
4 $11.00 182 shares ----
5 $12.00 167 shares ----
Total 930 shares 1,000 shares
Ending Value $11,160 $12,000
                       
   
In a rising market, you make money with either method, but you make less when you dollar-cost average. You can think of it as the price you pay in order to minimize losses should the market go in the other direction.
So what's an investor to do? The answer depends on your time horizon, and whether your primary concern is maximizing your returns or minimizing your risk. The shorter your time horizon, the greater chance you take of losing money with a lump sum investment. However, if you had $20,000 to invest, it probably wouldn't make much sense to invest $1,000 a year for the next 20 years. The market goes up more often than it goes down, and when it goes down, it eventually bounces back. It is almost certain that the price you would pay ten years from now would be higher than the price you would pay today, even if there were a major market correction tomorrow. In order to come out ahead, the dollar-cost averaging investor must pay an average share price that is lower that the initial purchase price of the lump sum investor. That's unlikely to happen over an extremely long time period.
     
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