When you have a large sum of money to invest (i.e from a 401k rollover), how do you invest it? I’m not asking about what stocks or mutual funds you should pick. When do you buy your investments? What is the right time? Over the last two years, the S&P 500 has had months that returned -7.2% to 10.8% (See YCharts). You can’t time the market, so you’ll need to use dollar cost averaging.
In this latest installment of the the “Learn About the Stock Market” series, you will learn about dollar cost averaging and I’ll show you how it works.
Definition: Dollar Cost Averaging
Dollar cost averaging is when you break up a larger investment into smaller investments over time. Instead of investing all of your money at one time, you break it up and invest smaller amounts over time in predetermined installments. Think of it like making car payments rather than paying cash for the car up front. Dollar cost averaging is not a means to boost your returns. Instead, it is a way to reduce your risk because you don’t know what the future brings.
Let’s take a look at a couple of examples. It is May 1, 2011 and you just received a check in the mail from your old 4o1k for $100,000. You want to roll it over to your IRA. If you invest $100,000 on May 1 (Blue Line), then your ending balance for the account would have been $114,982 at the end of April 2013. However, if you invested $10,000 each month from May 2011 to February 2012 (Red Line), your ending balance in April 2013 would have been $123,902. The difference is due to the sliding market in 2011 and by investing the full amount of front, you took the full brunt of the bad market. Dollar cost averaging lessens the impact of the declining market by only investing a small amount at a time.
Let’s fast forward six months to October 2011. Instead of receiving your roll over check in May, you received it in October. You invest the full amount in October (Blue Line) and in the end of April 2013, your account balance is $138,753. If you would have used dollar cost averaging (Red Line), your April account balance would have been $16,000 less.
I want to reiterate that dollar cost averaging is not a means to increase your returns. It is a way to reduce your risk.
Implement Dollar Cost Averaging
How should you go about implementing dollar cost averaging? There is no right or wrong way, nor is there a magic formula. The amount of money you have to invest should drive the decision on how many months to span your purchases. If you have less than $5,000, I would not recommend dollar cost averaging. However, if you have $10,000, then you could split the purchase over two months, $50,000 over 5 months, $1,000,000 over 1o or more months. Work with your advisor to come up with a plan. And if your advisor wants you to invest all of your funds up front, ask why?
As a special bonus this post, I’m providing you with a Microsoft Excel Spreadsheet where you can run your own dollar cost averaging scenarios using the S&P returns for the last two years. Thank you for joining me for another installment of Learn About the Stock Market.