PAY YOURSELF FIRST—AND REGULARLY—THROUGH DOLLAR COST AVERAGING

To remain financially responsible, everyone must pay bills on a regular basis. These bills include mortgages, utilities, car loans, and credit cards. Unfortunately, many people do not also heed the oft-quoted advice to pay themselves first.

The harsh reality these people may discover is that a steady saving and investing plan is sometimes necessary to help pursue such financial goals as paying for a wedding or new car, buying a house, and funding retirement. Financial experts disagree on the ideal way to invest in order to meet such goals, but one strategy can help you develop a systematic investing plan, while potentially saving you money and easing your mind along the way.  It's called dollar cost averaging (DCA).

DCA Defined

Dollar cost averaging is a technique often used in buying mutual funds in which investments of defined amounts are made on a regular basis. As a long-term, disciplined strategy, DCA can help you take advantage of the benefits of compounding to potentially build a sizable sum. Consider the chart below, which shows the result of investing $100 in stocks every month from January 1994 to December 2003.*

Dollar Cost Averaging

Large-cap stocks are represented by the monthly total returns of the S&P 500. Assumes a $100 monthly investment in the S&P 500 since January 1994.

Source: Standard & Poor's.   Stocks are represented by the S&P 500 Stock Index.

Other Long-Term Benefits of DCA

Another potential benefit of using DCA is that it ensures that your money purchases more shares when prices are low and fewer when prices are high. Over the long term, the result will likely be that the average cost you pay for the shares may be less than the average price. For example, see the table below. Assume you invest $50 per month in a mutual fund for 12 months and every month the share price fluctuates a bit. You can see that your $600 total would have bought you 42.7 shares. The average price per share, as calculated by adding up the monthly prices and dividing by 12, would have been $14.25. However, the average cost that you would have actually paid, as calculated by dividing the total amount invested by the number of shares, would have been $14.05 per share. Over the years, this method could potentially save you a lot of money.

The Benefits of DCA

In addition, DCA can offer the psychological comfort of easing into the market gradually instead of plunging in all at once. Although DCA does not assure a profit or protect against a loss in declining markets, its systematic investing "habit" helps encourage a long-term perspective, which can be soothing for people who might otherwise avoid the short-term volatility of the riskier, but potentially more profitable, investments, such as equities.

And last, DCA may help you make savvy investment decisions if you stick with it. For example, if your investment rises by 10%, you will likely post big gains because of the shares you've accrued over time. And if it declines by the same amount, take comfort in knowing that your next investment will purchase more shares at a less expensive price — shares that may regain their value and even exceed the higher price in the future.

Some Experts Say DCA Is Not the Best Strategy

Although investing a regular amount each month may be a sound way to develop a regular investing habit, some experts say that it may not be the best way to manage a financial windfall, such as an inheritance, a bonus, or even lottery winnings. A study by Peter Bacon and Richard Williams, professors at Wright State University, suggests that investing such a lump sum all at once as soon as it is received reaps greater financial rewards than DCA, albeit at a higher level of risk.

The study tracked lump-sum vs. systematic investments over 780 different 12-month periods from 1926 through 1991. Results indicated that an investor would have fared better 64.5% of the time by investing his or her money in a lump sum. This implies that if you have a large sum of money earmarked for the stock market, it should be put to work as soon as possible. Though past performance does not guarantee future results, stocks have historically risen the most over time.

Remember, however, that markets change over time, and this study may have yielded different results in more recent years. And, while you evaluate the relevance of the study to your investing needs, also consider the following situation: If you're 65 years old and you receive a $300,000 401(k) distribution, can you afford to take a chance that the market will drop shortly after you invest your retirement proceeds? If there's a sustained market decline, two years thereafter you might discover that your $300,000 life savings would be worth only $200,000! While chances are good that this wouldn't happen to you, and over time you might recover your investment, you have to weigh the consequences of loss before choosing lump sum vs. DCA.

Regular Investing Makes Sense

While investing a lump sum at the most opportunetime can potentially profit you more than if you dollar cost average your investment, defining "opportune" is difficult for even the most seasoned experts. As a long-term strategy, you may find DCA to be more appropriate to help lower your average cost per share, and allow you to feel more comfortable during uncertain markets knowing that you made sound investment decisions. Keep in mind, however, that you should consider your ability to purchase over long periods of time and your willingness to purchase through periods of low price levels.

Source: Standard & Poor's. Stocks are represented by the S&P 500.

Points to Remember

1. As a long-term method of making systematic investments of regular amounts, dollar cost averaging (DCA) can help maximize returns, lower your average cost per share, and soothe your concerns about uncertain markets.
2. DCA is a technique often used when purchasing mutual funds; over time, compounded assets can potentially amount to a sizable sum.
3. Because you purchase more shares when prices are low and fewer when prices are high, DCA can help you lower your average cost per share over time.
4. DCA allows the psychological cushion of knowing that investments are made gradually.
5. DCA does not assure a profit or protect against a loss in declining markets.
6. It can also help you make potentially savvy investment decisions such as value-oriented purchases.
7. One study done by university professors found that making lump-sum investments was a more profitable way of managing large sums of money than DCA.
8. While investing a large sum of money at the opportune time can be more profitable, defining "opportune" can be difficult even for experts.

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