Dollar Cost Averaging

So, let’s say you have $10,000 to invest (I wish I did, too). You could buy $10,000 worth of a stock -- all at one time -- and hope the value goes up. Or you could purchase shares of a stock in smaller bunches over a longer period time to increase your odds of buying at a lower price — and to decrease your market risk.

This tactic is called dollar cost averaging, and it could save you a lot of dough in losses should your stock choice crash. Still not making much sense? Let’s look at this idea a little closer, with a hypothetical example.

Dollar Cost Averaging by Example

Sally buys 400 shares of Microsoft at $25 per share, but over a two year time period, the stock falls to $10 per share. Sally has lost $6,000 and only owns 400 shares.

Bill, on the other hand, buys Microsoft shares slowly, spending $400 per month for two years. Over the course of these two years, Bill sees the cost of shares decrease, but he continues to buy $400 worth of shares per month. Every month, Bill is able to buy more shares, and he ends his two year Microsoft dollar cost averaging with 800 shares. Were he to sell his 800 shares at the $10 per share price, he would have only lost about $2,000.

However, if both Sally and Bill were to hang on to the shares until a market rebound at $25 per share, Sally would break even. But Bill would make money. Depending on when the share price fell, Bill could double his $9,600 investment.

Sign Me Up

Ready to invest in a dollar cost averaging investment plan? The plan sounds pretty foolproof for minimizing losses, but don’t stake your dollars without researching your best investment options. You should know before your purchase how healthy the company is and how much you believe in the products.

Even if you are minimizing losses by dollar cost averaging, you still want to maximize your earnings. If you believe in a company, it makes investing so much into one company easier to handle when the going gets rough.

For example, if Microsoft were to experience a major loss like in the example above, believing that the company will turn around will make it less painful to continuously dole out $400 per month to stock purchases. You believe Microsoft will rebound, so purchasing cheaper stock shares when they are down will be an awesome deal rather than a dreaded chore. Then, when Microsoft rebounds like you predicted, you’ll be dancing in money.

The key here is not to lose confidence when the stock goes down. That's the entire point of dollar cost averaging. If you don't buy when it goes down, then you're just missing out on an opportunity to get something you believe in at a cheaper price. Be ready to make this purchase before you start.

The Flip Side

Of course in our example above, if Microsoft skyrockets Sally will make a killing, while Bill will be left in the dust. All strategies have pros and cons, but dollar cost averaging can help make sure you don't take too much pain all at once. It's basically a way to insure against a worst-case scenario.

Other Tips

Some investment companies offer automatic withdrawal for a dollar cost averaging purchase, so speak to your investment professional about the best way to set this up. If this is not available, training yourself to purchase the same dollar amount of shares at the same intervals (weekly, monthly, quarterly, etc.) is as easy as scheduling the task on your calendar.

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Anonymous's picture

optionsdude wrote:

Mon, 04/04/2011 - 09:38 Comment #: 1

I love dollar cost averaging, especially for the reason you outline above. However, there is a technique called value averaging that you don't hear about much anymore. I read about it in a book by Edelson about 20 years ago. The concept is that you determine the amount of gain you would like in a particular investment. If the stock is down, you actually end up buying more than you would with dollar cost averaging and if the stock is outperforming your designated gain, you actually sell.

The book discusses its use with mutual funds, but it would work well with today's ETFs. It ends up being like dollar cost averaging on steroids. In a monte carlo simulation, it beat DCA 95% of the time.

Anonymous's picture

Anonymous wrote:

Mon, 04/04/2011 - 11:20 Comment #: 2

When I can lay my hands on some hypothetical money I'll try that out lol! It definitely sounds like a sound strategy!

Christa Palm's picture

Christa Palm wrote:

Mon, 04/04/2011 - 18:28 Comment #: 3

Welcome, Optionsdude! Thanks for the tip -- I will have to check out value averaging. It completely makes sense and sounds like a great tactic!

Jane, maybe you can shake a hypothetical money tree? If you find one, let me know :))

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