What is Dollar Cost Averaging?
“Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500.”
Definition of an Index Fund by Investopedia
Think of a mutual fund like a basket which holds any type of investment. For today’s article, we are looking only at the index mutual fund(s) which hold stocks. A stock Index Mutual fund holds in it’s basket a wide variety of stocks from all different types of companies. A stock index fund offers a low cost way to invest in a cross-section of companies.
An Early Lesson From My Dad
My parents were really smart about money and wanted to pass on their financial education to me. So when I was in my early 20’s, my dad started teaching me his business. He had a real estate company; but not your typical real estate firm; it was like a real estate firm-plus. Sure, he had people working for him, including my mom, who took clients around, showed them property and helped them through the sale, garnering a commission along the way. These agents also “listed” clients’ homes for sale and took a cut on that end too.
In addition to the commission based business he also had an “ownership based” real estate business. This one was the real money maker. He bought run down homes that needed a lot of work; fixed them up and either sold them for a profit or rented them out. Today, that would be called “flipping”.
This is the business he wanted to teach me.
In my 20’s, he helped me buy a dilapidated home, renovate it, and resell it. We picked the wall paper, the kitchen counters, and oversaw the workers who repaired the walls and floors. My dad was extremely generous in sharing this experience which created a foundation for my future. And the from the sale of that renovated house helped fund my first investments.
That was how I came upon a nice chunk of cash. Even back then, I was not a spendthrift. I had this money, and I knew I needed to do something to preserve and make it grow. So I opened a investment brokerage account with a stockbroker. Fortunately, I happened upon a decent broker who graciously responded to my never-ending barrage of questions.
I learned a lot from him, but the most important concept he taught me was: HOW TO BUY LOW.
Dollar Cost Averaging Drill Down
This one concept ensures that you will buy more stock when prices are low than when they are high. It is ideally suited to investing in mutual funds, and I bet some of you are already practicing this strategy.
Before I lay out the approach,investing in stock and bond mutual funds is only for long term investing (at least 5 and preferably 10 years or more) and will not need soon.
Dollar Cost Averaging – 6 Step Guide
- Decide on a specific amount of money that you can invest regularly; monthly or quarterly. Shoot for 10 to 15 percent of your gross salary.
- Determine where the money will come from; paycheck or bank account.
- Choose where you will purchase these investments, either your work 401(k) retirement account and/or a discount broker such as Vanguard, Charles Schwab, Fidelity, TD Ameritrade etc.
- If you have a work retirement account such as a 401(k) or 403(b), make sure to contribute some of your investment dollars there. If your employer matches your contribution, it’s essential to contribute at least enough to get the match.
- Choose the investments that you want to purchase. If you are just starting out get one or both of these type of stock mutual funds shown in the box below.
- Arrange with both parties; bank (or employer) and brokerage company to have the money transferred and designated to purchase your desired fund(s).
U.S. and International Stock Index Funds-Examples
U.S. stock market index such as Vanguard Total Stock Market Index (VTSMX)
International stock market index such as Vanguard Total International Stock Index (VGTSX)
Many mutual fund companies offer these types of funds.
(If you are investing in a work retirement account, choose the Index fund(s) closest to a broad based International and/or USA Total Market Index.)
Dollar Cost Averaging in Action
Monthly investment amount: $200.00
Investment choice: Vanguard Total International Stock Index (VGTSX)
|Month||Amount Invested||Price/Share||Number of Shares|
|*avg. price/ share|
When price is LOW-$8.39 (in February) you automatically BUY MORE-23.84 shares
When price is HIGH -$14.41 (in December) you automatically BUY FEWER-13.88 shares
Because you buy more shares when the price is LOW, than you do when the price is HIGH, your AVERAGE COST IS LOWER overall!
The simple tactic of dollar cost averaging guarantees that you will buy more shares when prices are lower and fewer shares when prices are inflated!
*Caveat: Before investing make sure you have taken care of these 3 steps first:
- Get rid of all credit card debt.
- Purchase term life insurance if you have someone (wife, husband, &/or kids depending on your income).
- Save at least 6 months living expenses in a bank savings account (on-line or bricks & mortar-it does not matter which).
Go to your work human resources office, get information about the 401(K) plan. Review your investment options and look for USA and International Index funds.
Open an account in a discount brokerage such as Vanguard, Fidelity, Charles Schwab, TD Ameritrade, etc. Check out their list of USA and International Index Funds.
A version of this article was previously published.
graph credit; google images_etrade.au