Monday, December 14, 2009

Understanding the Power and Benefits of Dollar Cost Averaging

Three friends were enjoying a barbeque when the topic of investing for retirement came up in the conversation. They realized that they all needed to start planning soon if they were going to be able to retire some time in the future. So, right then and there, they all made a pact to start investing as soon as possible. They all agreed to invest $5,000.00 a year to fully fund a Roth IRA and they would compare notes in 6 years to see who did the best. (By the way, $5,000.00 a year would be a little over $400.00 a month)

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All three friends stuck to the pact and invested the same amount of money every month for 6 years. Coincidentally, they all invested in funds that started at $10.00 a share. But that’s where the similarities ended.

The friend that chose the green fund increased every year for 6 years and ended up with at $15.00 a share. That’s a 50% increase. The friend that chose the red fun started dipping immediately, but by the end of the 6 years it finally broke even at $10.00 a share. That was a 0% increase. Finally, the friend that chose the blue fund was really bummed out because it really tanked. In the 6th year it started to rebound a little and ended up at $4.00 a share. That was a 60% decrease!

Which color fund would you wish you had chosen if you wanted the most money at the end of the 6th year?

Here are the surprising results at the end of the 6th year:

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You can see that all three friends started with a fund that cost $10.00 a share. So, $5,000.00 bought 500 shares at $10.00 a share.

However, for the friend that chose the green fund, the price of the shares kept on going up over the 6 years, so every year, $5,000.00 bought less and less shares. At the end of the 6 years, he accumulated 2,444 shares. 2,444 shares at $15.00 a share equals $36,660.00. He contributed $30,000 ($5,000.00 a year for 6 years), so he made $6,660.00 on his investment. Not bad.

The friend that chose the red fund had the price per share drop, so he was able to buy more shares during that time period. When the price went back up, the amount of shares purchased went down. All in all, at the end of 6 years, he accumulated 3,916 shares. Since the cost per share ended at $10.00, he ended up with $39,160.00. So, at the 6 year mark he made $9,160.00 on his investment. Surprising huh?

Finally, the friend that chose the blue fund had the price of the shares really tank and go all of the way down to $1.00 per share. But if you notice, the year it dropped to $1.00 per share he bought 5,000 shares with that $5,000.00. At the end of the 6 years he racked up 10,875 shares. So, even though the price per share was only $4.00, with 10,875 shares, he ended up with $43,500.00 -- a $13,500.00 return on investment! Now that’s shocking!

Here are some important things to take away from this story about Dollar Cost Averaging:
  • Dollar Cost Averaging is a lot like gravity – it works whether, or not, you believe in it.
  • Dollar Cost Averaging automatically insures that you will buy more shares at a lower price – and fewer shares at a higher price, over the long term.
  • Dollar Cost Averaging is working in equity mutual funds, even if no new money is added, because the “Dividends” and the “Capital Gains” can be periodically reinvested to buy more shares.
I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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