Monday, August 4, 2008

How to make volatile markets your friend: dollar cost averaging

Warren Buffet, one of the greatest investors of our time, is alleged to have said that he would pay a significant amount of money for the stocks he owns to decline 50% or more.

To find out why Warren feels this way, lets consider the following example of a hypothetical mutual fund:

The graph shows the share price on a monthly basis.  For this example, lets suppose that in January you started investing $100 per month into this fund.  As you can see, the fund didn't have a great year.  It lost almost half its value in the first two months, bounced around for a while before ending the year at a price of $4 - a full 20% decline from its price in December.

So in December you sit down to calculate just how much of your $1200 investment you have lost.  First, you look over your records to see how many shares you own.  You records show that you made the following purchases:

January 20 shares purchased for $5 each
February 25 shares purchased for $4 each
March 33 shares purchased for $3 each
April 29 shares purchased for $3.5 each
May 31 shares purchased for $3.25 each
June 33 shares purchased for $3 each
July 25 shares purchased for $4 each
August 33 shares purchased for $3 each
September 22 shares purchased for $4.5 each
October 25 shares purchased for $4 each
November 20 shares purchased for $5 each
December 25 shares purchased for $4 each

This gives you a total of 322 shares.  With the current price at $4 your shares are worth $1288.  You check over the math again because you don't believe it.  Even though the fund price went down, you managed to return over a 7% profit!

How did this happen?  Dollar cost averaging.

Dollar cost averaging is the process of making regular, usually monthly, investments into a mutual fund or other security.  By making investments at regular intervals you take the emotion out of your purchasing.  When the share price is low, your money goes farther, and you are able to purchase more shares.  It does not guarantee a profit, but it is a great way to invest.

Look at the above graph again and try to imagine how you would have felt investing in this fund as time went on.  From February to June, when the share price was the lowest you probably felt the worst about your investment.  But, now that we know how the year ended we can see that those were the best times to make purchases.  In those months, you were able to get more shares at a lower price.  This drove down the average price you paid per share to only $3.73 and you made a profit for the whole year.

Generally when things that you regularly buy go on sale, I am sure that you are happy about it.  This is often not the case with investments - but it should be.  If you are investing in low cost index funds or other well managed funds and are investing for the long term, any chance to buy them for a relatively low price is a good thing.  You should consider it your job to buy as many shares as you can, and the mutual fund's job to go up in price.  If it temporarily goes down, that just makes your job of buying shares easier.

Warren Buffet knows that he makes good investments and that in the long run they will pay off.  Therefore, he looks forward to opportunities to purchase his investments on sale.  You should too.

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