Dollar-Cost Averaging  

The object to dollar cost averaging is to invest a set amount of money at regular intervals so the average cost of shares tends to even out the market's peaks and troughs. Your dollars purchase fewer shares when the market is up, but they buy more when it's down.

While you may not achieve the positive results of buying at the market's low point and selling at its high point, neither will you suffer the consequences of doing the opposite. On average, in a generally rising market, you have the opportunity to accumulate wealth over time in a systematic, organized way.

In the long run, it doesn't matter when you start, just that you start. Over a long enough period, it makes little difference whether the market was up or down when you began.

Making monthly additions to your account allows you three times as many opportunities to benefit from favorable market swings as investing on a quarterly basis. On the other hand, of course, it provides three times as many chances for your account to be adversely affected by market swings. The more frequently you invest and the longer you keep investing, the smoother the average-share-cost line becomes.

A market decline can mean bargain prices. Unless you are selling shares, a fund's price quote in the daily paper is not relevant for anyone who is not planning to sell, so don't panic if it is down. In fact, a downturn provides the opportunity to buy more shares at attractive prices—shares that have the potential to grow in value when the market finally turns upward.

Be prepared to weather a sustained market decline. Keep in mind that in order for dollar-cost averaging to work, you must be prepared to commit the financial resources and have the resolve to make the contributions on each appointed date.

Regular investing does not ensure a profit and does not protect against loss in declining markets. Investors should consider their ability to invest continuously during periods of fluctuating price levels.

Example

In the figure below, we explain how effective dollar cost averaging works. For example, there are two investors, investor A and investor B. They both buy a mutual fund initially priced at $5 per share. They each invest $100 per month into their respective fund regardless of what happens to the fund price. The mutual fund that investor A buys generally grows over the year and ends at $10 per share. The mutual fund that investor B buys, however, drops and stays low for the entire year and finally ends up at $5 per share. 

Table 1

Which investment will provide the better return?

Before we answer the question, let’s look at the numbers. If we add up all the shares investor A bought through the year we end up with 173 shares. To get the ending value of investor A, we multiply the number of shares (173) by the ending price ($10 per share) to get an ending value of $1730. To get the ending value of investor B we multiply the number of shares (410) by the ending price ($5 per share) to get an ending value of $2050. So investor B ended up better.

Initially looking at the graph, you would assume that investor A had a better investment than investor B, but you would be wrong! Why did investor B do better? Because when you are dollar cost averaging you are buying the same dollar amount each month, but you buy more SHARES when the stock price drops. Look at the month of May for investor B; he bought 66 shares compared to only 17 shares for investor A.

Investor B ended up with more than twice the number of shares than investor A because the fund price stayed low throughout the year, thus purchasing more shares each month.

On another point, if the investors purchased a “lump sum” at the beginning of the year, then investor A would have doubled his investment in the end while investor B would have finished back where he started.

The advantage of dollar cost averaging is you don’t know what the markets will do in the future so you protect your assets by buying into the market gradually.