Tuesday, January 6, 2009

Madd Money: "Dollar Cost Averaging" Or "All In"?

It's a new year, so I've been thinking of the markets and such lately with the new year and a new time horizon.

I’m paraphrasing a quote that I saw on AllFinancialMatters regarding the approach of “Dollar Cost Averaging”. The idea is that, as investors, those of us who invest a set amount each month in a retirement fund (401k, IRA, etc.) often refer to ourselves as “dollar cost averaging” in the market. The point that I found interesting was as follows:

“Not only do people think that they are dollar cost averaging when they actually invest 100% of their savings each month via 401(k) plans or similar (…) but also that they ARE dollar cost averaging.”

Hmmm... I had never really considered this in this light, to be honest. I know that, when I sold all of my single stock shares last year, I decided to not just go out and buy a bunch of shares of a mutual fund or Index fund. Instead, I opted to take the better part of a year and exhaust the funds slowly and invest them in the market at a set rate over the course of a year. Generally speaking, this turned out to be a smart move, because the value of the shares declined over the course of the year, and many of the shares that I purchased, especially after October, were at a serious discount from what I was paying in April. So in this sense, this meets the criteria of Dollar Cost Averaging, and Dollar Cost Averaging is what I was doing.

Now let’s turn to the more common scenario that most of us are familiar with, and that is our regular contributions to a 401K plan, ROTH IRA, or some other option such as straight mutual funds or stock shares. If I were to, say, take $2,000 every month, and that $2,000 was invested in the stock market through an enforced savings and investment plan (self directed or otherwise), I’m not really dollar cost averaging. In fact, I’m making a lump sum investment. I’m just doing it regularly enough that it follows many of the same rules as Dollar Cost averaging (meaning I buy more shares when the price is lower than I do when the price is higher. Were we to, instead, place all of our money first into a money market fund, from the start or finish of a year, and then take that lump sum and each month put a little bit of it into stock shares… yes, that would be true dollar cost averaging. It might also be seen by many as a bad deal, too, because those shares while locked up in cash could have the potential to earn gains and dividends higher than the cash interest (of course, with greater payout potential comes greater risk).

I found this whole discussion interesting because of the original blog post topic, which was “how long would it take to get even” when it comes to recouping the losses of 2008. The original blog’s point is that it might take 4 to 5 years, if the individual in question were to have invested on December 31st, 2007 and then done nothing at all until December 31st, 2008. Fact is, most of us don’t invest that way, nor do we have the benefit of huge windfalls of money at any given time. Most of us need to stay the course, invest in up times and down times, and as time marches on, those boom and bust cycles, when mixed in with higher purchases of lower priced shares and the potential for dividend yields for those less costly shares netting us more of them, it’s entirely possible that we will do alright over the years it takes to come back to the original value. However, it won’t really be “returning to an original value". Instead it will be varying investments at varying rates, where one month may have gains, another month may have losses, and when all is said and done, and all dividends are reinvested, and more shares are picked up over time, the net rate of return at any given time may well be a good, if not spectacular rate. Given enough time, these factors work even more in the individual investors favor (generally speaking).

Thus, my plan is to stay the course and keep putting in the rate that I am, which it turns out is an all or nothing bet made twice a month for perpetuity. Should be interesting no matter what happens :).

No comments: