One of the first things I learned about as a financial advisor was dollar cost averaging. Part of the reason for this was the clients or potential clients I was talking to at the time. I was 22 years old (this is hard to believe) and getting started, so a lot of the people I talked to were also younger and getting started, accumulating funds in plans like 401(k)plans.
Dollar cost averaging is a useful concept when thinking about long-term saving, and it can be particularly useful with maintain perspective and discipline in declining markets. Oftentimes when markets are declining, a client may get their monthly statement and see a decline in value, even considering that they added money over the period. This of course can be disheartening and can lead a client to stop saving because what’s the point? That’s a mistake. In fact, the time to be systematically saving is when markets are declining, not advancing. Here’s why.
In my first example, Lance is saving in THOR (hypothetical ticker, our dog name). I’m saving $1,000 each month and THOR stock is very steadily climbing as illustrated below.
Amount Price per share Shares purchased
$1,000 $20 50
$1,000 $25 40
$1,000 $30 33.33
$1,000 $35 28.57
$1,000 $40 25
I’m feeling quite good about things. I’ve invested $5,000, have purchased 176.90 shares and at the $40 current price I have $7,076.
Diane experienced a much more volatile market. She got discouraged, especially by the third month when her investment had been cut in half, but she kept her discipline.
Amount Price per share Shares purchased
$1,000 $20 50
$1,000 $15 66.67
$1,000 $10 100
$1,000 $25 40
$1,000 $40 25
Diane invested the same $1,000, and despite (and because of) the volatility she purchased 281.67 shares and at the $40 current price she has$11,266. As is usually the case, she wins.
This is obviously an extreme hypothetical example, and it does require you to believe that in the end the prices recover, no matter what happens in the middle. But if you are saving systematically, especially for retirement, it’s a very long game, so the likelihood of price recovery from negative markets is high.
By maintaining discipline and dollar cost averaging even when (and especially when) times are bad, a long-term investor can actually applaud a negative market as an opportunity to buy more shares of their investment at lower prices, and as a result be on their way to accumulating long term wealth.
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