What is Dollar Cost Averaging?

Part of the University Finance Series

If you caught my article on "attitude money," you may have noticed one of the options for the "pay yourself first" plan was a brokerage account with any kind of regular deposit schedule. One of the really great ways to build up a base of stock investments is to use a strategy called "dollar cost averaging" to invest in shares over time.

Dollar cost averaging requires two things: one, it requires a commitment to invest over time, and two, it is obviously nice if the chosen stock's share price is increasing, even slowly. As an example, let's say we have Acme, Inc. stock trading at $10 a share. This is the stock we will use to begin a dollar cost averaging strategy for 12 months. Over each year, let's also say that Acme's share price increases or decreases linearly, or, increases or decreases the same amount each month over every 12 months. This is important for these examples.

In month one, we buy one share of Acme stock for $10. Then, every month following for at least one year, we buy one more share of stock. At the end of the year, let's say Acme, Inc. is trading at $15 a share. (50% annual return? Not bad eh?). Now, since you used a dollar cost averaging strategy, your average cost for each of your shares is your total cost of all shares divided by the number of purchases you made. Basically, each of those shares cost you about $12.50, which is the average cost over those twelve months. This is where the "cost-averaging" part of the strategy name comes from.

"Yes," you say, "but what if I bought all 12 shares in month one? Then I would have made more money!" Ah ha! You're absolutely right, grasshopper, however, there's more to the stock market than increasing share prices! Observe!

Part of the power of dollar-cost-averaging is that it will mitigate losses as well. What you are doing by averaging your cost is you are spreading out your risk from month to month. Suppose Acme Inc. started the year at $10 but was trading at $5 a share in month twelve? For anyone who bought 12 shares in month one, they just lost 50% on every share. Yow! But for our wise dollar cost averaging strategists, they lost less and less on every subsequent share purchase and lost nothing in month twelve.

Now what? Well, suppose Acme comes up with a great new way to defeat road runners and recovers in year two, and by the end of month 24, they're back to $10 a share? Guess what, grasshopper? You just made 50% on your month 12 share! In fact, you made money on every share except the first one you bought! Wow!

What about the guy that went all in month one? He hasn't made a cent. His shares have all broken even, sure, but he hasn't made anything because he bought all of his shares at $10.

This strategy works with just about any asset or investment with a changing price over time, including things like mutual funds and, to a certain extent, even bonds, as long as costs are limited. It is a perfect way to begin a "pay yourself first" strategy and a good way to manage risk while setting aside savings.