Smart: Scheduled Investing

When you invest in your 401(k) plan, with salary deferrals from each paycheck, you are performing a very smart strategy. It’s called dollar cost averaging. But the mechanics of how this scheduled investing works – and why it is so clever – are obscure to a lot of people.

This process is profitable when investing periodically over a long period by smoothing out the volatility of the market and giving you an average cost of your shares over time. Dollar cost averaging, or DCA, is the opposite of timing the market, where you hope to get in at the perfect time. (Something that is almost impossible to do.)

How does DCA work, exactly? Each pay period, the same amount is deferred and invested in your 401(k), regardless of the price of the underlying investments at the time. Since you always put the same amount into the account, you purchase fewer shares when the price is higher. When the price is lower, you purchase more shares.

Although DCA is more commonly used with 401(k) accounts, this strategy can be used with any type of investment, including 403(b)s, individual retirement accounts and stocks.

For example, let’s say that you defer $100 every two weeks into your 401(k) plan, and your investment is an index fund. For the first pay period, the price of the fund is $10. When you make your deferral and purchase this time, your $100 gets you 10 shares.

In the next pay period the price of your index fund shares increased to $10.50. Now your $100 purchases 9.5238 shares, and you have a total of 19.5238 shares, at a price of $10.50 per share, for a total account value of $205.

On the following pay period the price falls to $9.50 per share. Your $100 buys 10.5263 shares of the fund – you now have a total of 30.0501 shares at a price of $9.50, with a total account value of $285.48.

The table below plays out purchases with random amounts over a year and then tallies the result:

The table shows random prices between $9 and $11.99 over the 26 pay periods. In real life, your investments probably don't have such wildly fluctuating values over the course of a year. I use this degree of fluctuation to demonstrate the benefit of DCA when the investment is relatively volatile.

If, instead of investing $100 every two weeks, you saved up the entire $2,600 yearly deferral and invested it at the end of the 26th pay period. So you purchase all of the shares at $11.41, for a total of 227.8703 shares. With DCA, your $2,600 increased in value over the year and your 245.0105 shares are worth $2,795.57 – a net benefit of $195.57.

On the other hand, if you had $2,600 to invest at the beginning when the price was $10.55 per share, you have 246.4455 shares, worth $2,811.94 at the end of the year. But you don’t know then that the market will be up 12 months later.

Of course, a lump-sum investment is only possible if you have $2,600 in cash, and you can tolerate the volatility that buffets your portfolio for a full year. Also, it's easier for most people to defer a small amount each pay period rather than save up a large amount of cash.

You can see from the table that with dollar cost averaging, you pay an average price per share over the period. You’re purchasing exactly the same dollar amount of shares every time. When the price is high, you buy fewer shares, when the price is low you buy more shares.

 By doing this over a long period, such as 30 years, you avoid the risk spending a large sum of cash on inflated shares by comparison over the savings period.

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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.

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