What is Dollar Cost Averaging?

When it comes to investing, dollar cost averaging refers to investing an amount of money in a stock or mutual fund at regular time intervals. The idea behind this investment strategy is that you are getting a lower price when the market is down even though you are paying a higher price when the market is up and, overall, the average price you pay is lower than what get from investing a lump sum. At first, this may not look consistent with my previous post on The Golden Rule... of Investing: Buy Low, Sell High, but let's take a look at an example to see how you can benefit from this strategy.

Assume you invest $100 every month for five months into a given stock. The stock price at each of these purchase dates is as follows (with the number of shares purchased):

Jan.: $20 (5 shares purchased)
Feb.: $14 (7.1 shares)
Mar.: $13 (7.7 shares)
Apr.: $15 (6.7 shares)
May: $23 (4.3 shares)
Total: $85 (30.8 shares)

The $500 invested purchased 30.8 shares, resulting in a cost per share of about $16.23. This means that when the stock price is above $16.23, there is a gain on the investments.

But what if the May stock price was still down around $15 as it was in April; what are the results then?

Total: $77 (33.2 shares purchased)
The $500 invested purchased 33.2 shares, resulting in a cost per share of about $15.06. A gain would exist when the stock price is above $15.06. The May price is not above that price so there is no gain until the stock increases.

So what do we learn from these examples? That Dollar Cost Averaging is not necessarily going to give you better returns; it completely depends on the stock performance over the given period. So does that mean I should just invest the $500 all at once? Well, if you did that in Jan. in the example, you would be even worse off since your cost per share would be $20 instead of $16.23 or $15.06. If you invested the $500 in Feb. you would be better off with only a $14 cost per share. Since we don't know how a stock or mutual fund will perform, investing continuously over a period diversifies away much of the market risk (the risk of market fluctuations). Also, most individuals do not have enough money to make a single investment now to carry them through to retirement, but rather have smaller amounts set aside each month as income is received. Another way to take advantage of continuous investing is by reinvesting dividends rather than having them paid out. This can be done automatically by your financial institution or brokerage.