The phrase, “dollar cost averaging” is a popular investment expression that is frequently bandied on television and radio. In fact, millions of Americans routinely practice “dollar cost averaging” through their work sponsored retirement plans such as a 401(k) or 403(b) via the system of payroll deductions. However, many people still have questions about the “theory” of dollar cost averaging. Common questions include: What is dollar cost averaging? How does it work? What is the principle behind dollar cost averaging? Is there any risk of loss?
1. What is dollar cost averaging?
One of the simplest definitions of dollar cost averaging is that it involves investing a fixed amount of money at a predetermined interval of time (i.e., $100 on the 8th of every month). The theoretical assumption of dollar cost averaging presupposes that the amount invested will purchase fewer units when prices are high and more units when prices are low, thereby “smoothing out” market fluctuations. As with all theories, the “theory” of dollar cost averaging rests on a few key assumptions:
A. It is geared towards long-term investing; generally a time horizon of at least 15 years or more.
B. It assumes that by investing over a long period of time, an investor can reduce risk and cost. This last assumption is open to vigorous debate and certainly has many vocal critics! It is well worth noting that dollar cost averaging does not insure against loss of principal and/or interest (or dividends).
2. What are some of most common investment vehicles for dollar cost averaging?
The “system” of dollar cost averaging is most frequently utilized in retirement planning. For example, many employers have established retirement savings plans such as a 401(k) that invest in mutual funds. Employees who are eligible to participate in their employer’s 401(k) will have a specific amount of money deducted from their salary weekly, biweekly or monthly which will then be invested in one or more mutual funds. Individuals can also utilize dollar cost averaging by setting up an automatic investment program with a mutual fund company. A fixed amount of money is withdrawn from the individual’s checking account on a predetermined date in order to purchase fund shares. This method is commonly utilized to contribute to an Independent Retirement Account.
3. Are there any other types of investments that utilize dollar cost averaging?
Dollar cost averaging can also be used to purchases shares in a Dividend Reinvestment Program (DRIP). A dividend reinvestment program enables an investor of a stock to invest dividends that go towards the purchase of additional shares of the company’s stock. Many companies have dividend reinvestment programs. Special note: one has to be an existing shareholder in order to participate in the DRIP. In order to enroll in a DRIP, the stock has to be registered in your name and not in “street” name (“street name” refers to stock certificates registered in the brokerage firm’s name). Therefore, investors who want to enroll in a DRIP need to instruct their brokerage firm to register the stock in their name. Quite a few companies offer direct stock purchase plans (DSPP). In order to participate in a DSPP, an investor will purchase shares directly from the company’s authorized agent. Enrolling in a DRIP or DSPP merely involves filling out and sending the appropriate paperwork along with the accompanying payment or contribution to the administering transfer agent. Perhaps, one of the most salient features of a DRIP account is that it allows an investor to make “optional cash payments” with minimal fees. The company or the administering “transfer agent” will invest the proceeds from the “optional cash payment” quarterly (this can sometimes vary) as this is when dividends are generally paid to shareholders. Dividend reinvestment plans and direct stock purchase plans can range widely in terms of policies. Every company will have a slightly different structure and it is crucial to review each plan carefully. Investors should consult with an experienced financial advisor in order to develop an appropriate investment strategy. Participation in a DRIP or DSPP, as with any investment strategy, does not guarantee against loss of principal and/or interest nor ensure a profit.
Cautionary points about dollar cost averaging:
1. Dollar cost averaging is not a panacea for building wealth overnight or even over time. Stock and/or fund shares when redeemed may be worth more or less than their original purchase price. There is no such thing as a “safe” stock, investment or even company. Some of the most stalwart names in American corporate history have incurred financial bankruptcy and subsequent liquidation. Sadly, they no longer exist today as viable business entities and are now relegated to the past. It is crucial to evaluate your investment holdings regularly (as well as the companies in which you own stock and mutual fund companies) in order to ascertain if your investments in these companies are still viable.
2. Dollar cost averaging cannot protect your investment in a declining market. It can neither protect you from a loss nor guarantee you a profit in declining market conditions.