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11.3: Dollar-Cost Averaging and Mutual Funds, Revisited

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    79794
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    Video - Audio - YouTube (Material for this section starts on slide 22.)

    Dollar-Cost Averaging, Revisited

    Recall that dollar-cost averaging is a system of buying an investment at regular intervals with a fixed dollar amount. We essentially set our investment program on autopilot. We don’t worry about when it is a good time to invest or when it is not a good time to invest. This technique is another method to help remove emotion from our investing program. Recall the conversation we have with ourselves. With dollar-cost averaging, whenever we wake up in the morning, there is always good news. “The market is up! Good news! Our account is worth more!” or, “The market is down! Good news! Next month, we will get more shares at a lower price when the $50 or $100 comes out of our paycheck or checking account.”

    Dollar-cost averaging also has another trick up its sleeve. Let’s take a look at a very volatile three month period. The first month, you invest $100 into an investment at a price of $10. You receive 10 shares, $100/$10. The next month, the price falls to $5. You invest another $100. This time, you receive 20 shares, $100/$5. Fortunately, in the third month, the price recovers to $7.50. This month, you purchase 13.333 shares, $100/$7.50. It appears that you have broken even, buying shares at $10, $5, and $7.50. However, because you purchased fewer shares at the high price and more shares at the lower price, you have actually turned a profit. You invested $300 over the three month period. Yet you now have 43.333 shares at the current price of $7.50 which is worth $325.

    Magic?! Hardly. Again, by investing the same amount each month, we are purchasing fewer shares when the prices are high and more shares when the prices are low. Our average cost per share should be lower than our average price per share. (Memorize that sentence. Think about it often.) In this case, the average cost per share was $6.92, $300/43.333 shares, while the average price per share was $7.50. You know what comes next, right? Using dollar-cost averaging will not guarantee a successful investment outcome. Dollar-cost averaging is not going to turn a lousy investment into a profitable one. If the investment continues to lose money year after year, we are going to wind up with a whole lot of very worthless shares!

    However, the absolute best benefit that comes from dollar-cost averaging is that it makes investing very simple and straightforward. We simply have $50 or $100 or whatever we can afford come out of our paychecks or checking accounts each month. Of course, this is much easier for mutual fund investors. It is a bit more tricky for stock or bond investors but not impossible. We just need to allow the cash to accumulate until we can make our purchases. But then again, technology and innovation in the brokerage industry is advancing rapidly. Some brokerage firms such as Schwab are now allowing investors to purchase miniscule fractional shares with as low as $5. (Please check what kind of markup and markdown the brokerage firm is offering. Our guess is that it is not the most advantageous to the investors. We contacted Schwab and asked what kind of spread we can expect from their fractional share purchases and sales. The representative said he would get back to us. He never did. Hmmm. We will try again soon but we have a sneaking suspicion that they really don't want us to know.)

    Mutual Funds and Diversification, Revisited

    Speaking of mutual funds, wasn’t diversification one of the two main reasons why so many investors choose mutual funds? Yes! The other is professional money management. Mutual funds help us reduce our risk by spreading out our $50 monthly investment over hundreds of stocks or bonds. But does that mean mutual funds necessarily have less risk than individual portfolios or the market as a whole? Well, it all depends on which mutual funds we are talking about. Some mutual funds do a very good job of reducing risk. In the assignment for this chapter, we ask you to research the standard deviation and other popular measurements of risk for at least five mutual funds.

    But what about the mutual fund investors? Did the inherent diversification in their mutual funds help them? Recall that most mutual fund investors do worse than the mutual funds they invest in. Revisit the graphic below and note how mutual fund inflows tended to follow strong market performance. When the markets fell, many mutual fund investors then ran for the exits and sold … at the worst possible times! Don’t be an average mutual fund investor. Keep a long-term perspective and dollar-cost average. Remember: Mutual funds will bore you to wealth.

    A graphic showing the inflows and outflows of money into and out of mutual funds. Many mutual fund investors, "Buy High, Sell Low." Don't be one of them.


    This page titled 11.3: Dollar-Cost Averaging and Mutual Funds, Revisited is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.

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