Employer-based retirement plans provide a powerful mechanism for W-2 employees to reduce their tax liability and save for retirement. But far too often people do not take advantage of this important benefit. The reasons for not participating or under-participating are varied, but many lose out because they imagine using a 401 (k) to be a difficult and complex process. And, based on this assessment, decide it is not worth it and not for them. Others believe there is no benefit to long-term investment. These perceptions are understandable, but are demonstrably incorrect and harmful.
One big advantage that comes along with 401 (k) participation is automatic dollar cost averaging.
What Is Dollar Cost Averaging?
Dollar cost averaging is investing equal amounts of money, at regular, pre-set intervals, in the same mutual funds (or other investment vehicles), regardless of the price of the mutual funds and no matter what is happening in the markets.
3 Advantages of Dollar Cost Averaging
Dollar cost averaging has a number of advantages.
First, it takes the emotion out of investing. The same amount of money is invested, every time, no matter what. Sticking to a disciplined, dollar cost averaging plan removes the temptation to try to time the market and reduces the chances of reacting emotionally and committing the big, unfortunate – and all too common – mistake of buying high and selling low.
Second, over time, dollar cost averaging may allow an investor to pay a lower average price per share for their investments. In short, by dollar cost averaging, an investor buys more shares when the share price is lower and fewer shares when the share price is higher.
A simplified illustration underscores the point:
|Month||DCA Amount||Share Price||Shares Purchased|
Average Share (Market) Price: ($50 + $40 + $60 + $30 + $50 + $80) / 6 = $51.67 per share
Average Share Price Paid via Dollar Cost Averaging: $3000 total / 63.75 total shares = $47.06 per share
Finally, dollar cost averaging can provide some peace of mind. It allows an investor to get started investing without committing everything they have all at once and, thus, without being concerned that a quick market drop will substantially reduce their portfolio. And, in times of market decline, it can help to limit the effect – including the significant psychological effect – of short-term investment losses.
Automate It. Let Your 401 (k) Do The Work.
For many people, the toughest part of investing, and especially dollar cost averaging, is sticking to a disciplined plan. In other words, staying the course and sticking to the plan every day, week, month, year, and decade, no matter what and whether the markets are up, down, or sideways.
A 401 (k) makes it easier by allowing an investor to fully automate the investing and dollar cost averaging process. Once you have set up your 401 (k) account, selected your investments, and decided how much you want deducted from each paycheck, the rest happens automatically, every time you get paid.
This automation is almost magical. You never see the money in your day-to-day bank account, so after a short adjustment period you probably will not miss it. And, aside from annual or other periodic reviews, there is almost nothing else you will need to do to effect your steady investment plan. It just happens. Because it just happens you are less likely to succumb to emotion – i.e., to buy high and sell low. And over time, with a steady, disciplined, and automated dollar cost averaging approach, your retirement investments are likely to grow; providing a better (more fun!) and more secure retirement.
Note that outside of a 401 (k) and in a bull market there may be some risk of reduced returns with a dollar cost averaging plan versus a lump sum investing plan. To illustrate, if you have $50,000 and invest it all in an S & P 500 Index Fund, and then the S & P 500 Index goes up in a meaningful way, you may reap greater rewards than if you invest $500 a month in that same fund via dollar cost averaging and keep the balance in cash as you effect the plan. But this potential risk is limited and to a great extent inapplicable within the confines of a 401 (k) account. Because, by using a 401 (k), you are investing as soon as you receive the money. Thus, there is no lump sum to invest or sitting on the sidelines– you are investing, and dollar cost averaging, immediately and automatically every time you get paid.
Automatic dollar cost averaging is a powerful tool in your 401 (k) can be a powerful tool. It can allow you to eliminate the emotion that can lead to bad investing decisions and can keep you on track from now until you retirement, years or even decades in the future.
As always, whenever engaging in financial planning and operations, consulting with a trusted and knowledgeable advisor is always a good idea. To get involved – or more involved – with your 401 (k), speaking with your employer and your current 401 (k) provider are likely good first steps. They can provide direction and assistance along the way.