Dollar Cost Averaging: A Better Way to Save?

This is a guest post on dollar cost averaging. I like this strategy for “ordinary” investors with small amounts of money who want to build a nest egg over time.

Wait! Don't hit the back button just yet. I know that there's a lot of bad publicity on dollar cost averaging (DCA). But let me lay out both positive and negative arguments first. My basic point here is to show you when and how to use DCA to maximize your investments.

Definition of Dollar Cost Averaging

Dollar Cost Averaging (DCA) is an investment strategy that requires investing equal monetary amounts periodically in a certain stock or portfolio over a certain time period. A simple dollar cost averaging plan could be something like buying $100 worth of Wal-Mart (WMT) stock every month for the next five or twenty years. The idea behind this is to lower the total average cost for the shares purchased over time. More shares are bought when prices are low, and fewer shares are bought when prices are high.

Pros of Dollar Cost Averaging

The main advantage of this approach is the fact that it lets you ease into an investment. It doesn't require you to have a large amount of capital to get started in investing. This is perfect for individuals who currently don't have a lot of cash but can set aside a small percentage of their income for investing on a consistent basis.

Another advantage of DCA is that it lowers your total average cost per share. Since this program lets you buy more shares when stock prices are low and fewer shares when prices are high, your cost per share will thus average out. This is argued to effectively reduce your risk on volatile swings in the market price.

Take Advantage of DCA through Compounding

Investors can use DCA to take advantage of compounding (earning interest on previous interests and principal) via Dividend Reinvestment Plans (DRIPs). These are basically direct stock purchase plans offered by companies to small investors. As the name implies, DRIPs reinvest any dividends earned by shares into more shares, can be another form of compounding.

Since DRIPs are basically a form of DCA, I'd like to point out their major advantages for investors.

• Starting is easy and cheap. You can enroll in a DRP with the initial purchase of just a single share.
• Your investment is compounding. It will grow much faster than regular interest-bearing instruments.
• Some companies offer shares at a discount to their DRP investors, further lowering acquisition costs.
• Regular investments can be as small as $10 to $50.
• There are no brokerage fees (for company-run DRIPs).
• You are invested for the long-term. This maximizes the power of compounding and eliminates the need to time the market.

Cons of Dollar Cost Averaging

The number one argument against DCA is the fact that your investment will underperform against the rest of the market when prices are strongly trending up. This is because you can't bet big now (and thus win big) with a DCA approach.

Another argument against DCA is that its benefit is small compared to the lost returns from waiting to invest the money over time. Investing now is always better than investing tomorrow. Your money can be put to work early and productively. That is if you currently have money and if you're certain that the instrument you're investing in will yield a definite positive return (like with bonds, but not necessarily for stocks).

Examples of DCA

Here is a simple dollar cost averaging calculator. Enter the ticker symbol of any company. Then, add a monthly investment amount and the start and end dates. Click calculate returns (this calculator doesn't account for stock splits so the real ending dollar amount would be bigger than what will be displayed). I suggest you take it for a spin and try out some scenarios. For example, try looking at the end figures of some stocks in the Dow Jones Industrial Average if you put in $50 a month (with dividend reinvestment) for a period of 30 years going back.

If you try that for Citigroup (C), you'll see that if you started buying $50 worth of Citigroup stock every month from June 1982 up to June 2012, you'd end up sitting on stocks worth $253,363.81 today. What's amazing here is that the total dollar amount that you invested during the entire time period only amounts to $18,050.

Now try the calculator for other stocks like Coke (KO), IBM (IBM), or McDonald's (MCD). As you may notice, some stocks will make you say wow and some will make you say woof. Of course, the results will vary depending on the stock you pick, so you still have to do your research. This just shows that DCA does not give you immunity against bad stock picking.

If you're just starting out and itching to get some money saved and invested, you can try dropping that $3 Starbucks (SBUX) latte every day ($15 per week) and put the money in DRIPs of solid, growing companies.

Jason S. Ramos is a contributing author for WealthLiftInsider.