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!