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Dollar Cost Averaging – The Basics

By: Investor Solutions

By: Frank Armstrong, CFP, AIF

Dollar-cost averaging has been described as one of the oldest, leastexciting ways of investing. But almost everyone agrees on its validity. It’s a powerful tool for investors to accumulate wealth over their working lifetimes. But you don’t want to use it as a strategy if you already have a lump sum of money that you can invest all at once, like in the case of an IRA rollover or if you won the lottery. We will explain why in a subsequent article.

For folks in the accumulation mode (for example, 401(k) investors or systematic savers) will find that this strategy produces a lower cost per share on their purchases than those who try to time their purchases to buy at the lowest prices. As you will see dollar cost averaging is a very simple discipline. It requires investing a set amount of money at regular intervals in a particular investment over a period of time.

The advantage of dollar-cost averaging is apparent when you sell a larger number of shares at a higher price. Remember, you accrued more shares because your investment bought them over time at a lower price.

Simple Example

A simple example illustrates the concept:

You decide to invest $1,000 in your favorite stock on the first of each month for three months. The first month, the stock sells at $100 a share; you buy 10 shares. The second month, the stock falls to $50 a share and you buy 20 shares. The third month, the stock recovers to $75. Your $1,000 investment buys you 13.3 shares.

You now have 43.3 shares that you bought at three different prices for a total outlay of $3,000.

Dollar Cost Averaging Sample

Month Amount Invested Price Per Share # Shares
1 $1,000 $100 10.0000
2 $1,000 $50 20.0000
3 $1,000 $75 13.3333
Total $3,000   43.3333

The stock is currently selling at $75 a share, so your 43.3 shares are worth $3,247.50. That’s an 8.25% profit. Also, your average cost per share is less. If you divide the average price per share by your total investment of $3,000, your average cost per share is $69.28.

Amount Invested $1,000 x 3 months $3,000

Current Value $75 x 43.333 $3,250

Average Cost/Share $3,000 / 43.333 $69,2308

Of course, this is a hypothetical illustration. It does not imply a guarantee of a specific return on any particular security. It does not take into consideration taxes, inflation, and costs in purchasing stocks, which should all be factored in when you figure your return on investment.

A 401(k) plan is an excellent way in which to implement dollar-cost averaging. Since money is deducted each pay period from your earnings and placed into the 401(k) plan, you will find that you have paid less per share over time if your choice of investments remains constant for a substantial length of time.

Reinvestment of dividends and capital gains is a form of dollar-cost averaging and one of the smartest things investors can do. Also, with few exceptions, reinvesting costs you nothing in terms of loads or fees.

If you do decide to use the dollar-cost averaging strategy, you need to bear in mind that, although it has been a highly successful investment technique in most instances, it neither assures a profit nor protects against losses in a down market. Dollar-cost averaging works only if you continue to purchase systematically, regardless of whether the market fluctuates up or down. As such, you have to stick with the program to get the best benefits. The longer you stick with it, the higher the probability that it will work for you.

Another point to consider, the discipline of making regular investments over time prevents us from falling into the trap of emotional market timing decisions. Emotional decisions have a way of coming back to haunt us more often than not.

Finally, many investors are impaired by paralysis by analysis. They always want to wait to “see how thing are going to turn out”. Dollar Cost Averaging gets them started. It’s an emotional crutch that helps them to do the right thing. Whether we like to admit it or not, all of us need emotional crutches at times.

Dollar cost averaging is a time tested, proven, highly reliable method to gather wealth. It should be a key part of every accumulation plan.