My Family’s Money

Dollar cost averaging is an investment strategy that seeks to minimize market timing risk by spreading the investment of a large sum of cash over a fixed period of time.  This investment strategy is not without its critics. Though hailed by many personal finance experts and bloggers as a great investing strategy, DCA has not been as widely accepted among academics. According to its detractors, there are three main problems with dollar cost averaging: it increases overall transaction costs, doesn’t meaningfully protect you from timing risks, and in most cases provides sub-optimal performance as compared to other methods of investing.

I will cover the later two objections in future posts, but for now I want to focus on understanding how dollar cost averaging increases the amount money that most investors are going to fork over to brokerage firms or financial institutions.

An example is always helpful, so lets take a look at the the hypothetical finances of Vlad the Impaler.  Having seized the fortunes of many a boyar, Vlad decides that it is time to invest in the always growing American stock market.  He has a lot of cash on hand, about $3,600 US, but the instability of his native Wallachia has left Vlad a little risk adverse.  He wants to keep his money safe, so he decides to adopt a dollar cost averaging strategy over the course of a 12 month period.

Inspired by Sam Waterston’s Jack McCoy on NBC’s Law and Order, Vlad has taken a fancy to TD Ameritrade and opened an online trading account with this discount broker.  As of this writing, TD Ameritrade offers trades at a flat rate of $9.99.  This isn’t the lowest fee out there, but I think it will help us get an understanding of what the DCA critics are talking about.

Now that we have our basic assumptions on the table ($3,600 invested over 12 months with a cost of $9.99 per transaction) let’s examine the impact of the transaction costs on Vlad’s investments:

Using a dollar cost averaging approach with Vlad’s stash of cash is going to eliminate over 3% of the cash that he was seeking to keep safe using this investment strategy. Granted, if Vlad’s windfall was 10 or 100 times what we used in this hypothetical situation the impact would have been reduced to .3% and .03% respectively – but who suddenly finds themselves with $36,000 or even $360,000 laying around with nothing to do with it except invest in the always growing American stock market?

In the end, a dollar cost averaging investment strategy can substantially increase costs for investors. Unless you go with a no fee brokerage firm (like Bank Of America or Zecco ) you are going to see some portion of your hard earned money go to financial middle men. This in and of itself shouldn’t stop you from dollar cost averaging if you choose, it is just something that you definitely want to take into consideration when deciding what investment strategy works best for you and your money.

Today marks the beginning of my second year of blogging at My Family’s Money. It hasn’t seemed like a year since I first penned my inaugural post that I titled “I Want Gold“  – but it has been.   Time has marched on, leaving its tread on my bearded cheek.

A lot of wonderful things have happened to me and my family since I started this whole “internet” thing.  I had a baby, and it was a boy.  Holding him in my arms is like staring at a bleeding sunset and having my scalp massaged at the same time.  Just thinking about it is giving me goosebumps.  No doubt that my little man is going to impact my family’s financial future – but I have a sinking feeling that getting to know him is going to be worth every cent.

In terms of blogging, I feel like I have written some interesting and semi-useful articles over the past year.  Probably my favorite (and at one time, insanely popular) is my post about pet monkeys.  I haven’t produced anything nearly as educational or fun.

Some of my other favorite posts/series over the past year have included:

• Why We Are Committed to Living Debt Free
• Ethiopia, Equality, and the Principle of Fairness
• Six Financial Lessons Learned From Going Poop
• Budgeting: A Guide to Sanity and Wisdom
• Emergency Funds Are the Coolest

Probably my most useful post  (“useful” being defined as getting the most clicks from the search engines) include:

• Calculating A Paycheck for a Raise
• Calculating A Paycheck for a New Pay Schedule
• Dollar Cost Averaging and the Great Depression
• Budget Hack: Sumif to the Rescue
• Dollar Cost Averaging in a Declining Stock Market

Blogging over the past year has been a lot of fun and a lot of work.   It has been a great pleasure to be useful and entertaining to those that have found my site and I am incredibly greatful to all those that have commented or linked to my content.

Here’s to another year of blogging!

At 00:24 on November 20, 2008 my son was born.  My family of two has now officially become a family of three.   I am very, very excited about getting to know my little boy and hope that our journey together until one of us dies is an exciting one in which love flows freely, knowledge is sought and dispensed, and all three of us become better people.

Earlier on in our pregnancy I had some serious questions concerning the cost of having kids and set out on a journey to record all the money that we spent up until the birth of our son.  I haven’t gotten the final tally together for how much it cost me and my wife to birth our son, but the preliminary numbers are looking very good.

Helped along by some very generous friends and family who either gave us their no longer needed children’s clothing or who bought us things that we needed outright, we incurred very little out of pocket expenses except for some medical bills.  I am estimating that we spent somewhere around $2000 to have our baby.

I plan on continuing this experiment, but I’m not too sure how to proceed given that detecting small changes in our spending habits will be difficult to track.  I don’t want to be spending my time calculating how much gas we burned traveling to a doctor’s appointment or some similarly trivial expenditure.  I’d rather be spending that time with my family.

Annual percentage yield (APY) is an important metric for savings accounts and certificates of deposit that states the true return of an interest rate over the course of a year when compounding is taken into consideration.  Most banks will tell what this is up front, so calculating it yourself isn’t really that important – but we all know that doing things for yourself is where its at!  Besides, it is nice to know how financial institutions come up with the numbers that they give consumers so that we can make informed decisions about the financial products we use.

For the sake of our calculating example let’s take a look at a savings account.  I still bank with WaMu (really Chase) so I will use the current interest rate on their Online Savings Account for this demonstration.  The interest rate for the account is 2.23% with a posted Annual Percentage Yield of 2.25%.  If you are like me you want to know how these numbers are calculated, so lets take a look at the basic equation for APY:

Don’t let the variables in the equation confuse you, they are actually pretty simple when you take a look at them:

inom – this is the nominal interest rate for your account.

N – this is the number of compounding periods in a given year

Lets plug in the numbers from my WaMu account to see how the equation will look with some real numbers:

I have plugged the nominal interest rate, here 2.23%, rate as a decimal, .0223.  Also, since most savings accounts I am aware of compound daily (but deposit interest monthly) I have made the number of compounding periods 365.  You can do this fancy little equation by hand, or you could copy and past the following string of text into a Excel or Open Office Calc:

=(1+.0223/365)^365-1

If you want to play around with these numbers to see the different results you might get, I recommend opening up your spreadsheet and doing the following:

• In B2 type Nominal Interest Rate
• In B3 type Compounding Period
• In B5 type APY

Now let’s set up the APY equation.  To do so:

• In C5 type =(1+C2/C3)^C3-1

You should be able to type any interest rate into cell C2 and any compounding period in C3 that you want to calculate an annual percentage yield for and this equation should do the math for you in no time.