Dollar Cost Averaging for New Investors
What dollar cost averaging is and how it works in a portfolio
Once you begin building your investment portfolio, you are bound to hear about a technique called dollar cost averaging that has been around for generations.
While there is some disagreement regarding the extent to which dollar cost averaging can reduce market risk, there does seem to be a general acceptance of the idea that an investor who follows a dollar cost averaging plan, buying and selling regardless of market conditions at regular intervals and/or in fixed dollar or share amounts, might be able to better withstand the emotional dangers of overconfidence or panic during times of extreme stock market volatility.
In effect, the secret to dollar cost averaging is that it helps strip emotion out of the challenge of capital allocation. For inexperienced investors, particularly those who are buying baskets of securities or things such as low-cost index funds, this can be a major help. In truth, irrational investor behavior abounds in trying times.
What Is Dollar Cost Averaging?
Dollar cost averaging can best be described as a formulaic approach to systematically investing either a fixed amount of currency or acquiring a fixed number of share units at predetermined intervals to slowly build a position in a security.
That is, instead of investing assets in a lump sum, the investor works his way into a position by slowly buying smaller amounts over a longer period of time. It spreads the cost basis out over several years and at different prices, providing insulation against future changes in market price. It means that during times of rapidly rising share prices, the investor will have a higher cost basis than he or she otherwise would have had and during times of collapsing stock prices, the investor will have a lower cost basis than he or she otherwise would have had.
An Overview of How an Investor Might Setup a Plan
To begin a dollar cost averaging plan, an investor needs to do three main things.
- Decide exactly how much money he or she can invest each month. It's important to make certain that the amount committed is financially prudent and affordable so the amount can remain consistent over a length of time. Otherwise, the plan will not be as effective.
- Select an investment or group of investments that he or she wants to hold for the long-term with long-term being defined as at least five or ten years.
- At regular intervals - it can be weekly, monthly, or quarterly, for example - invest that money into the security he or she has chosen. If his or her broker offers it, our investor could even set up an automatic withdrawal plan, so the process becomes automated at little to no expense. It might also be possible to do without a stockbroker.
It's easier to demonstrate the mechanics of a dollar cost averaging plan by walking you through a hypothetical example. Imagine that you have $15,000 you'd like to invest in shares of ABC, Inc., a fictional company.
The date is January 1st. You have two choices - you can invest the money as a lump sum now, walk away and forget about it, or you can set up a dollar cost averaging plan and ease your way into the stock. You opt for the latter and decide to invest $1,250 each quarter for three years.
Over the subsequent three years, your money is invested at the following prices:
Table 1: Hypothetical Dollar Cost Averaging Plan
- 1st Quarter Year 1 = $50.00 stock price, $1,250.00 investment = 25.00 shares purchased
- 2nd Quarter Year 1 = $40.00 stock price, $1,250.00 investment = 31.25 shares purchased
- 3rd Quarter Year 1 = $70.00 stock price, $1,250.00 investment = 17.86 shares purchased
- 4th Quarter Year 1 = $50.00 stock price, $1,250.00 investment = 25.00 shares purchased
- 1st Quarter Year 2 = $30.00 stock price, $1,250.00 investment = 41.67 shares purchased
- 2nd Quarter Year 2 = $20.00 stock price, $1,250.00 investment = 62.50 shares purchased
- 3rd Quarter Year 2 = $25.00 stock price, $1,250.00 investment = 50.00 shares purchased
- 4th Quarter Year 2 = $32.00 stock price, $1,250.00 investment = 39.06 shares purchased
- 1st Quarter Year 3 = $35.00 stock price, $1,250.00 investment = 35.71 shares purchased
- 2nd Quarter Year 3 = $51.00 stock price, $1,250.00 investment = 24.51 shares purchased
- 3rd Quarter Year 3 = $65.00 stock price, $1,250.00 investment = 19.23 shares purchased
- 4th Quarter Year 3 = $50.00 stock price, $1,250.00 investment = 25.00 shares purchased
Had you invested your $15,000.00 at the start of the time period, you would have purchased 300 shares at $50.00 per share. At the ending stock price of $50.00 per share at the close of year three, your position would have been worth exactly the same $15,000.00.
However, through the regular purchases of your hypothetical dollar cost averaging program, you ended up investing $15,000.00 and getting 396.70 shares as your fixed investment of $1,250.00 per quarter was able to buy more shares when the stock price collapsed and fewer shares when the stock price appreciated. Even though the ending stock price was $50.00, the exact same amount as three years prior, your stake has a market value of $19,839.50.
To take it one step further, under the dollar cost averaging scenario, your stake would break-even at $15,000.00 if the stock was trading at $37.81, which is a 24.38 percent decrease from the initial purchase price.
This phenomenon was visible in the accounts of 401(k) investors who regularly contributed to their retirement savings regardless of stock market conditions in the years following the stock market collapse of 2009. Those low-cost basis purchases helped bring down their overall cost basis, so when the market recovered years later, they were able to enjoy the rewards for their patience and discipline.
The primary downside of dollar cost averaging is that if you experience a stock market bubble, or you are averaging into a position that experiences a significant increase in value, your average cost basis will be higher than it otherwise would have been.
Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.