Dollar Cost Averaging: Would You Prefer 1 Dart or 12 Darts to Hit the Bullseye?

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Nearly every day, I hear or read about the phrase “dollar cost averaging“. Rarely, will an actual definition or chart accompany this phrase.

Wikipedia defines it as:

Dollar cost averaging is the practice of investing a fixed dollar amount at regular intervals (such as monthly) in a particular investment or portfolio, regardless of its share price.

In other words, it means you buy $X amount of stock each time you contribute to your Roth IRA or 401k retirement accounts.

Of course, that sounds simple but for some reason, it still seems to confuse a lot of people.

I tend to process information visually, so seeing an actual chart of a real dollar cost averaging regiment works far better than a simple definition. Plus, most people (at least from my experience) want to follow someone’s example when it comes to their investments to avoid making a mistake.

Example of Dollar Cost Averaging

Take for example, a Traditional/Roth IRA contribution plan. Where, each month, your goal is to contribute 1/12th of the annual contribution for 2008 ($5000/12 = $416.66).

If you contributed $416.66 per month at the beginning of each month (see chart), your monthly contributions would have purchased shares at the corresponding price indicated by the green arrows.

…

It doesn’t really get more simplistic than this. In fact, most people dollar cost average into the stock market using their employer’s 401k retirement plan without even knowing about it since their paycheck is automatically deducted and wired to their 401k account every two weeks.

The critics will argue that dollar cost averaging does not allow you to buy stocks at the low points or get the best price possible. They’re right — it doesn’t.

Problem is, no one has a working crystal ball — to my knowledge — and dollar cost averaging allows you to multiple attempts to buy stocks (mutual funds, index funds, bond funds, etc.) at reasonable prices when you feel the marketplace is giving you an attractive buy signal.

Think of it like throwing a darts at a dartboard: would you rather have 1 dart or 12 darts?

Pretty easy choice isn’t it?