Dollar cost averaging is one of the most powerful concepts that affects you as a retail investor. It is also one of the simplest, most effective, and virtually idiot-proof ways to get both time and math working for you.
You get time working for you, because regardless of how much money your have to invest, you can get started right now. Because you choose the amount you are able to invest, dollar cost averaging also allows you to make regular investments at a level that you can afford throughout the year. Once making these investments becomes one of your monthly money habits, you won’t even notice the “missing” money. Consider it a monthly bill; one that must be paid not to a bank or utility, but to your future self.
Dollar cost averaging gets math working for you because you automatically buy more shares when stock prices are lower, and buy fewer shares when stock prices are higher.
Dollar cost averaging in action
Lets look at an admittedly simple, but illustrative, example:
An investor decides he wants to invest in company ABC. He wants to invest some money every month. The current price of ABC is $10. He has $100 to invest, so he buys ten shares. The next month, the price of the shares has doubled to $20. Again, he invests his $100. The following month, the shares have fallen to $5. Somewhat reluctantly now, he invests his $100 again. Finally (for our example) the shares return to their initial price of $10. Undecided as to whether or not to continue with his plan, our beleaguered investor sits himself down to have a think as to whether or not this is working. The shares went up initially, yes, but then they plunged to half of his original purchase price. Most recently, they moved back up, so they’re back where they started. Have I moved forward? he asks himself. Yes, he has, and more than he probably realizes.
The average price of the shares over these four months is indeed $10. $300 invested in shares that average $10 seems, at first blush, like should result in owning 30 shares. Well, first impressions are wrong in this case. The actual number of shares owned is as follows:
Month 1: $100 invested at $10 per share = 10 shares
Month 2: $100 invested at $20 per share = 5 shares
Month 3: $100 invested at $ 5 per share = 20 shares
Current number of shares owned: 35
Current value of shares: $350.
Where did those “extra” 5 shares come from? They came from the fact that when the stock price is down, a particular amount of money buys more shares. Dollar cost averaging helped our investor buy not only more shares; it also helped him get those shares at a cheaper average price. This has the effect of skewing the average cost of the shares down because more are bought when the stock is trading lower.
In terms of his return on investment, those “extra” five shares means he is up more than 16% in just four months.
Don’t leave before reading this!
There are indeed stocks that soar and plunge as ABC does in this example, but they’re the types of stocks I avoid like the plague, and, with respect, if dollar cost averaging is a new concept to you, I strongly suggest you avoid those particular stocks at this time as well. The principle of dollar cost averaging, however, is sound. Regular amounts of money, invested over time in both up and down markets, will help you effectively build your savings. You need to allow time for the strategy to work, and even more importantly, you need to be sure that you have a properly diversified portfolio because dollar cost averaging does not save you from companies that go belly up. As I write this, RIM has just re-named itself BlackBerry, and released for sale (in Canada only) the long-awaited BlackBerry 10. By the time you read this (months or years into the future) you will be able to see either how dollar cost averaging could have made you a bundle (if the stock recovers) or how you could have lost your investment (if the stock eventually goes to zero). Either way, you need to understand that there is no reward without risk. Dollar cost averaging does not eliminate the risk of buying stocks. (Nothing eliminates the consequences of a stock becoming worthless) but what it does do is let you benefit from both regular investing through the months and years, and from the ups and downs of the market.
A personal confession
DCA is a great idea, and it really works, but only when you actually do it. Over the past several months, I’ve been leery about putting new money into the market, and so I’ve let a bit of cash pile up. The result? If I had done as I know I should have done, and bought regularly, I’d be in a better overall situation than I am now. At least I didn’t go all-in and sell my holdings, waiting for the market to drop, as I have mused about doing elsewhere.