So I was goofing around with my own investment records when I realized that I had a great way of showing the advantage of dollar-cost averaging. As you may recall from the mutual fund primer, dollar-cost averaging lets you reduce the variance (to use a poker term) by spreading out your investment over time.
Here’s an example using some real world numbers (Vanguard 500 Index Fund). The following are share prices at the end of every quarter for two years.
Date Price/Share 6/21/2002 $91.22 9/27/2002 $76.37 12/27/2002 $80.73 3/28/2003 $79.69 6/20/2003 $91.94 9/26/2003 $92.08 12/26/2003 $101.15 3/26/2004 $102.30
From June 2002 – March 2003, the price/share of the fund dropped 12.64%. So if you had taken your maximum $2000 IRA contribution and stuffed into this fund in June and looked at your balance in March, you would have been pissed off.
From June 2003 to March 2004, the fund’s price/share increased 11.27%. If you had put in $2000 in June and looked at your balance in March, you would have been pretty psyched.
Overall, from June 2002 to March 2004, this fund saw its share value go up by +12.15%. Your $4000 investment over two years would be valued at $4468 for a gain of 11.71%.
But what if you had practiced dollar cost averaging? That is, dividing your $2000 in fourths and investing it over the year?
Date Price/Share Trans. Amt Shares 6/21/2002 $91.22 $500.00 5.4813 9/27/2002 $76.37 $500.00 6.5471 12/27/2002 $80.73 $500.00 6.1935 3/28/2003 $79.69 $500.00 6.2743 6/20/2003 $91.94 $500.00 5.4383 9/26/2003 $92.08 $500.00 5.4301 12/26/2003 $101.15 $500.00 4.9432 3/26/2004 $102.30 $500.00 4.8876
From June 2002 to March 2003, you would have seen a drop in the value of your investments of only -2.40% because 1/4 of your shares were purchased at the high price of $91.22, but the other 3/4 were purchased at lower prices (lower prices also translate into more shares).
From June 2003 to March 2004, you would have seen a gain in the value of your investments of only 5.88% because at least half of your shares were purchased at higher prices.
Overall, however, you would have seen a gain of 15.59% on your $4000 investment for a final value of $4,623.47 (remember, the lower prices enabled you to buy more shares during 2002-2003, which translated into more wealth when the fund price topped $100 in 2004).
This demonstrates that dollar-cost averaging not only works to reduce your risk, but in this particular example, allows you to outperform the index itself!