Dollar Cost Averaging: How Have Your Investments Done?

Earlier this month I fully funded my 2009 Roth IRA, and while I am going to contribute $5,000 to the Roth IRA in 2010, but I’m not planning on contribution all $5,000 at once. Starting in May, I am going to contribute about $300 every other week when I get my paycheck. By the time December rolls around, I’ll have contributed the maximum and reached my savings goals for the year.

Dollar-Cost Averaging is a strategy that gives you a good sense of the market over time, so you are not buying high and selling low, as so many people do.

If I had $5,000 on January 1, 2010 and $5,500 on January 1, 2011, it would be pretty clear how well I did: a 10% return on my investment. However, since most people don’t deposit money all at once and wait a year to see how it does, we need tools to figure out how we’ve done.

Before I assume that my $5,000 investment meant 10%, it’s important to take a step back and look at when I invested and how much at each point. Taking a deeper look into your investments can reveal much more than meets the eye.

By dollar cost averaging, we don’t contribute all $5,000 at once but over a period of time. Consider this situation: From January through October of 2009, I contributed $500 on the first of the month toward my IRA. Once I had $5,000 invested, I realized that I had maxed out my contribution and stopped investing. On January 1st, 2010 I had $5,500, a $500 return. So how did I do with my investments?

Well, $500 made on a $5,000, so that must be 10%, right? WRONG

Since the amounts were contributed at different points of the year, we’ll use Excel’s XIRR function to figure this out.

This chart reveals that our 10% estimate was way off and we actually made 16.29% on my $5,000 investment!

Feel free to click on that chart and download it. You can plug in your own investments and dates and figure out how you’ve done this year.

After entering the amount invested and the date (add as many extra rows as necessary, remembering that your contributions should be negative numbers because that money is being subtracted from your bank account), look at how your annualized returns are doing. It gives you the best sense of how you’ve done so far, and at the current pace, how you would do over the course of a year.

Using this method is great if you don’t make contributions just once a year or if you are looking at a period of time other than full years. If you’ve been using dollar-cost averaging, you may be performing much different than you think!

On Monday, we have an interesting guest post that explores this further and teaches us to get the most out of our investments. Stay tuned!

9 Responses to Dollar Cost Averaging: How Have Your Investments Done?

  1. Monevator says:

    Hi, I think there’s a typo in your write up, as the table says 16.29% but the copy says 11.69%. :)

    I totally agree with dollar cost averaging as the best approach for most people.

    The average person doesn’t need to time his investments to do the very best, he or she needs to avoid the worst outcomes. DCA does that for you.

  2. Daniel says:

    Nice catch, all fixed.

    I like that line:”The average person doesn’t need to time his investments to do the very best, he or she needs to avoid the worst outcomes.”

    We don’t need to achieve perfection, especially if it trying means taking on more risk. Doing pretty well is more than enough for most people.

  3. Thanks for the table. I never actually thought about this aspect of return. I normally keep up with how much we invested and how much we have now. I only work out the percentages once in a while since we are so far away from it actually meaning anything…

  4. Eric says:

    I am personally not a big fan of using dollar cost averaging to look at investment performance. While dollar cost averaging can help give you an overall birds eye view, I like to look at each specific investment on its own. If I buy the same stock twice for $1000 and make $200 on investment one and lose $200 on investment two, I did not break even. I made one good investment and one bad investment.

    If I can learn from each specific investment decision, I can hopefully eliminate the bad ones as I go forward. Giving myself an undeserved happy feeling or being hard on myself over an average of multiple investments is not a fair approach, in my humble opinion. I do see the value of the approach, I just don’t think it gives the most accurate snapshot.

    I do like your detailed look into each specific step in a monthly investment. Most of us do investment monthly for retirement, so doing the lump look is not as accurate as you broke it down. Great post!

    • Daniel says:

      @Eric, Doesn’t that remove the luck aspect of investing. Sure, if you lost $200 that sucks, but maybe you didn’t give it enough time or you bought while everything else in the market was also declining. By cost averaging, you don’t put all your eggs in one basket and you get a snapshot of the market over a longer period of time.

  5. Moneymonk says:

    Wow Daniel, good analogy

  6. sahmCFO says:

    Last year (in mid-March 2009) I helped my brother open up his Roth IRA. He put the MAX in at that time because he was using it as a 2008 contribution for tax purposes and missed his chance to DCA. It worked out for him (buying near bottom) but his beginners luck has fueled his confidence. I’m going to show him a chart of what would happen to his $5000 if he had put it all in during a market peak.
    I think for the average investor, dollar cost averaging is the best way to avoid overbuying/under-buying during the peaks and valleys…

  7. Dr Dean says:

    I think some have this “dollar cost averaging” thing confused.

    Dollar cost averaging is just a method of buying an investment over time, rather than in a lump sum. You can dollar cost average a mutual fund, or a single stock or several of each.
    You can’t judge each individual investment by looking at the whole, as Eric is suggesting. Each investment has to stand on its own merits.

    Putting your investment in all at once requires you to pick bottoms, which has been shown to be impossible- or potentially buying at the top, even worse.

    So for Daniel’s spreadsheet to be most helpful, it should be about one investment choice, not the total portfolio, unless his investment choice represents his total portfolio-which I think is true of his example.

    I dollar cost average most of my investments. One good technique, especially if you are just building wealth outside of an IRA, is to buy stocks you want to purchase in a Dividend Reinvestment Plan, or DRIP. I, for example, bought over a year or two 500 shares of Southern Company in a DRIP-(no commission) by purchasing in 500 dollar increments. This evens out your purchase price. Then, when you hit the number of shares you want, leave it alone and let it grow….letting those dividends reinvest.

    Of course this only works for dividend paying stocks, and stocks you plan to hold for a long term.

    Great post and interesting subject.

  8. Congrats on your fully funded your 2009 Roth IRA! I’m looking forward to your Monday post. I need advice on retirement planning :).

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