As I mentioned earlier, I recently bought into the Vanguard 500 using part of my emergency fund. Since then, I’ve set up a monthly deposit into that fund, intending mostly to focus on building up the balance to a sufficient level. The real purpose of the fund is to enable my wife and I to do some interesting things when our children leave for college, such as quitting our “normal” jobs and focusing on public service at the local level.
What I realized is that using an automated investment system amounts to dollar cost averaging. By doing it this way, I’m basically committing myself to a dollar cost averaging approach to my investment.
If you’re unfamilar with dollar cost averaging, it’s an investment philosophy that involves you buying into a particular investment over time with an equal amount of cash each time. When the investment’s value is high, you don’t get as many shares; when it’s low, you get more shares. Over time, this can reduce the pain of a down market. Essentially, because of my monthly investment plan, I’m now doing dollar cost averaging into the Vanguard 500, buying the same dollar amount in shares each month and riding it through the ups and downs.
Here’s the question: is this a good thing? Lots of financial advisors think that dollar cost averaging is the cat’s banana, but I’m not entirely convinced. Let’s look at a year in which the value of a stock starts at 100, goes up 10 a month until June (the peak), then stays steady for the rest of the year. You paid $134.94 per share with dollar cost averaging. If you instead bought in at the start of the year with your complete investment, then you paid only $100 per share.
On the other hand, let’s look at the reverse market: the stock starts at 100, goes down 10 a month until June, then stays steady the rest of the year. If you invested it all right off the bat, you spent $100 a share for stocks now worth $50, but if you used dollar cost averaging on a monthly basis, you only paid an average of $58.66 per share.
Dollar cost averaging is good if you think there’s a good chance that the market will see turbulence or go down. It will reduce the impact of the collapse on your investing. On the other hand, dollar cost averaging doesn’t do so well if the market is going crazy.
Since I think the market is going to be turbulent, but not go up or down a whole lot overall in 2007, I think that dollar cost averaging is fine for me in the short term.