Dollar Cost Averaging: The Basics

Dollar Cost Averaging FTW!

I am a very new investor and I am historically very risk adverse. I have always like the idea of earning money from other people’s labor, but until recently I have always been pretty scared to invest. Right now I am working hard on acquiring $2,500 to open an account with an internet brokerage firm and reading what I can to understand stocks, bonds, and mutual funds.

There is a lot of information out there about not only how to choose stocks, but also how to purchase them. I still don’t know very much about how to choose stocks, but I think I am starting to get a handle on different stock buying strategies. There are a couple main ideas about how to purchase stocks, but there is one that seems to get a lot of attention from personal finance gurus and amateurs alike. They call it “dollar cost averaging” (but it may be more appropriate to call it “make a lot of small bets-ing”).

The main idea behind dollar cost averaging is to purchase stocks or mutual funds at a fixed time interval with a predetermined amount of cash. It really does not matter what your interval is or how much you invest as long as you are consistent and use it for long periods of time (7-10 years by some estimates). By keeping your time horizon long you are attempting to capitalize on the historic upward trend of the market.

Important Dollar Cost Averaging note: Many people get a little confused when they talk about dollar cost averaging as an investment strategy. They think that any strategy that buys stocks on a regular basis is a DCA approach. This is simply not the case.

The term “dollar cost average” only applies to situations where an individual has a large sum of money that they invest over a period of time at regular intervals, doing so to minimize the timing risk associated with investing their large sum of money. Therefore, investing $100 in the stock market every paycheck is not dollar cost averaging – it is simply investing.

Here is an example of how dollar cost averaging works: Peggy Sue comes into $2400 from an aunt on her mother’s side of the family. She decides that she wanted to put this money to good use earning dividends and growing with the stock market. Being a little risk adverse, Peggy Sue goes with a dollar cost averaging approach to investing and decides to invest her entire sum over the course of a single year.

She invests in a low expense ratio mutual fund that attempts to mirror the market since the vast majority of mutual funds under perform the major indexes and individual stocks represent more of a challenge than she is ready for. Each month Peggy buys $100 worth of this fund no matter what the market price is. When the fund is cheaper her $100 buys more shares, and when it is more expensive her $100 buys fewer shares. Because of this dynamic, Peggy Sue will always be paying less per share than the average price at which she made all of the transactions. To see this, below is real data from a stock that consistently declined over a 12 month period:

Dollar Cost Averaging: A Down Year

The average cost at which the shares were purchases was $10.18 (the sum of the buy prices divided the total number of buy prices) while the average cost per share was $10.02 (total amount invested divided by the total number of shares). If this were Peggy Sue’s situation, she is now is poised to take advantage of a rise in the funds value since she stuck with it through the decline. The fund would have to rise to a value of $10.02 from its current price for Peggy Sue to break even with her investment if she were to stop dollar cost averaging now. Here is the hypothetical rebound of the fund over the course of the next year of the market (the previous year is shaded in grey):

Dollar Cost Averaging: The Rebound

At the end of the next year Peggy’s position is worth $2,663.87 (shares she own multiplied by the price of the stock – 255.16 x $10.44) when she paid $2,400 to acquire it, representing an 11% return (or you could view it as a $1.03 profit per share). For a moment lets imagine two different scenarios to help us understand the advantages and disadvantages of dollar cost averaging: the perfect timing scenario and the worst timing scenario:

  • Perfect Timing – this scenario will help us see the opportunity cost of dollar cost averaging. If Peggy had invested the entire sum ($2,400) at the markets bottom ($7.11 per share) she would have a position worth $3,881.85 at the next highest point ($11.50), representing a 61.74% return ($4.39 per share). The perfect timing scenario is 326% better than dollar cost averaging!
  • Worst Timing – here Peggy makes the worst blunder of all in buying the stock at its highest point ($12.61) and selling at its lowest ($7.11). This is the scenario where you get “injured, injured bad ” in a proverbial kick to your investment gonads. If this were to happen you would see a loss of 43.62% (-$5.50 per share). The worst timing scenario is 634% worse than dollar cost averaging. Yikes.

Dollar cost averaging will in all cases but one be better than the worst timing scenario but never better than perfect timing. This stock purchasing strategy effectually reduces your risk of catastrophic failure (worst timing) by sacrificing your ability to maximize the gains possible in a position (perfect timing). How much protection dollar cost averaging offers against these two extremes depends largely on the market conditions and on when you decide to pull out of your chosen fund or stock. Overall, dollar cost averaging is a relatively safe investment purchasing strategy for long term goals, enabling you to autopilot your investing while minimizing timing risks. You still need to pick a good stock or mutual fund that has a level or upward trend over the long term to fully reap the benefits of dollar cost averaging.

This article was included in the Carnival of Personal Finance #154 at Canadian Dream: Free at 45