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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Saturday, April 17, 2010

Pro’s and Con’s of Dollar Cost Averaging

Dollar cost averaging (DCA) is a technique often used by investors to reduce the risk of buying into an investment at a high price. It involves spreading out your purchases over time by investing fixed amounts at pre-determined, fixed intervals. For example, if you planned to purchase $60,000 of a real estate mutual fund, you could DCA by buying $15,000 a quarter for four quarters or $10,000/mo. for 6 months. If the price of the fund dropped during that time period, you would buy more shares as the price dropped, resulting in a lower average cost than if you purchased $60,000 in a lump sum.

In a recent article in Financial Planning magazine titled “Set Investors Straight” (February 2010), author Dan Moisand points out: “The longer clients use DCA, the greater the odds that the averaging will actually work against them. This is because markets rise more often than they fall.” Mr. Moisand goes on to say: “Here’s proof: Pick any month between January 1926 and August 2009 as your start date. Fast forward to one month later, and the U.S. stock market will have risen in 62 out of 100 instances.” And, he points out that the longer the time frame the more likely it is that prices will rise.

It seems to make sense, therefore, to not use DCA when investing. If you’re a long-term investor, and believe the market will rise over the long haul, then DCA should be avoided. Even though this makes sense, there are some people who have a difficult time investing large sums of money. Getting them to act at all can be difficult. If you’re this type of person, DCA can help you get over that hurdle and at least take action. While perhaps not the best way to invest, DCA can help you diversify your portfolio and avoid leaving your money sitting on the sidelines earning a paltry quarter of a percent in some money market or savings account.

There may be other instances where DCA could make sense. If one was planning to invest in an asset class that has been on a recent tear with shares considered by many as over-priced, DCA may be a prudent way to slowly take a position. While this smacks of market timing (which we believe is difficult to do), it can help investors get past emotions that keep them from investing wisely.

On another note, there are times too when reverse dollar cost averaging (RDCA) can be used to help investors reduce holdings that need to be pared for a variety of reasons. The holding may be over-priced, it may constitute too great a portion of their overall portfolio or there may be a poor outlook for the asset. Obviously, if the holding is likely to depreciate in value for whatever reason, it makes sense to sell the required shares in one transaction, ASAP.

It’s not unusual, however, for investors to resist selling. Sometimes they don’t want to pay capital gains taxes. Other times, the stock was passed down to them by their Aunt Lillie. How could I sell that? Seller’s remorse is a common hurdle (They are sure the price will rise as soon as they sell). Selling portions over time can get you past these road blocks. If the asset goes up in value, you feel good because you still own some. If it goes down, you feel good because you didn’t sell it all. While perhaps not the best strategy, RDCA can get you off dead center and at least get you going in the right direction. Progress, while not perfect, is better than no progress at all.


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