What is Dollar Cost Averaging?
It is a technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of share price. The investor purchases more shares when prices are low and fewer shares when prices are high. In Laymen’s terms, dollar cost averaging is spending money at regular recurring schedule without considering the cost.
A few examples of dollar cost averaging you may already do in your everyday life:
Buying gas each week for your vehicle
Bi-Weekly/Monthly 401k investment purchases through employer
Grocery shopping (sometimes we get that block of cheese on sale, sometimes we pay full price)
Why choose a Dollar Cost Averaging strategy?
It takes the decision (emotional) part out of pulling the trigger (you do not have to sit and watch and try to time the market for opportune times to buy).
You protect yourself against market fluctuations and minimize risk by buying less shares at high price and buying more at a lower price
The focus shifts to accumulating more assets/shares rather than making the quick buck
How do we know this is the right strategy?
Longer term investment is required and this approach is generally good for volatile investments (stocks, ETFs, mutual funds)
You protect yourself against market fluctuations.
If done correctly, this strategy will allow an increase in shares and an average reduced per share price
What else should you know?
It is important to still manage the dollar cost averaging
Need to set up spend limits and schedule a recurring purchase
This strategy does not guarantee a return
You should be comfortable enough in an investment to hold for the long term (no “in and out” or checking on it daily)
Example Scenarios: Invest $100,000 in a calendar year
In January, the share price of XYZ stock is $100 per share. The share price of XYZ stock fluctuates throughout the year and at the end of the year (December) the share price of XYZ stock is $90.
Scenario 1: Invest all of the $100K in January buying XYZ stock at $100 per share (total shares purchased is 1,000).
At the end of the year (December):
Since the share price of XYZ stock is $90, the market value of your shares of XYZ stock is $90,000.
Number of shares purchased/owned: 1,000
Scenario 2: Evenly distribute your money over the course of the year (purchase $25K of stock in the months of January, April, July, and October).
In January you purchased $25,000 worth of shares at a share price of $100, thus you were able to purchased 250 shares in January.
In April you purchased $25,000 worth of shares at a share price of $90, thus you were able to purchase 277.7 shares in April.
In July you purchased $25,000 worth of shares at a share price of $70, thus you were able to purchase 357.14 shares in July.
In October you purchased $25,000 worth of shares at a share price of $90, thus you were able to purchase 277.7 shares in December.
At the end of the year (December):
Total shares purchased/owned: 1,162
Market value: $104,580
As you can see in this example and generally in investing in the market, the best strategy is dollar cost averaging. It is simple and effective. Dave Ramsey always says "never jump into the market!!"