Earn higher returns by investing regularly

If you invest a fixed amount of money in a mutual fund periodically, you can boost your returns. This method, called dollar cost averaging, is a simple way for investors to accumulate wealth and earn a good return on their investment. If you have a certain amount of money to invest, it is better to purchase equal value of the investment at periodic intervals.

There are obvious reasons for which dollar cost averaging is very beneficial. First it lets you avoid taking a big stake in a security when its value may be high. If the security loses a value initially, it can take a long time for you to recover the initial loss. Since I have never been able to time the market, I like buying periodically. Second, most of us with a paycheck get paid at periodic intervals. Setting up an automatic investment plan that invests money at these intervals also helps from a cash flow perspective. But the third reason that I like dollar cost averaging is that it can help you get a higher return on your invested capital. This is because when you purchase a fixed value of a fund periodically, you automatically buy more units when the price is lower and buy fewer units when the price is higher. This results in a higher return on your investment. Today, I am going to illustrate this with a contrived example.

Let’s take a mutual fund whose price on December 1^st and August 1^st was $100. Let us assume that we were on an automatic investment plan purchasing $200 worth of this mutual fund at the beginning of every month. Our total investment in this example for the 5 month period would be $200*5 or $1,000. The price of the mutual fund varied over the dates when we purchased the stock. On the first of Aug, Sept, Oct, Nov, and Dec, a mutual fund unit was priced at $100, $70, $100, $130, and $100. The following table illustrates the number of units that we would purchase over time.

The value of our investment at the end of 5 months is $1,040. The total money we invested was $1,000. This resulted in a return of 4% over the 5 month period. So although the mutual fund price went up by 30% and went down by 30% off the price you purchased, you still came out ahead.

We can explain this magic of dollar cost averaging as follows. In Sept, when the price of the mutual fund was lower, because we were still purchasing mutual funds worth $200, we purchased more units (2.86 units). In Nov, when the price of the mutual fund was higher, we purchased fewer units (1.54 units). Since we are investing the same amount of money every month, we automatically purchase more units when the price is lower and purchase fewer units when the price is higher, giving us higher returns. In the above illustration, if we had invested the entire capital of $1000 on August 1^st, our return would have been zero. This example is made-up and assumes a very high volatility to amplify the impact and has the same price in the first and last period to make it simple. But it is still useful to illustrate the benefit of dollar cost averaging.
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