Learning to Manage Money

What is Dollar Cost Averaging?

Dollar Cost Averaging  is an investment strategy where you are investing static amounts of chunks of money spread out over time (instead of a lump sum purchase) in a given investment.

You might be wondering “what is the advantage of doing this form of investing”?  You might think that investing in small chunks is inferior to lump sum investing because depending on the investment vehicle, it can seem be more expensive because of transaction costs versus a lump sum purchase.

A lump sum purchase is were you take all the money that you want to invest and purchase an investment all at once instead of in small purchases via a dollar cost averaging method.

So let’s now look at how the Dollar Cost Averaging ideology works.

Below is quarterly purchases of the fictitious stock XYZ:

Amount
Price of the Amout of Cumulative Value of
Invested Date XYZ Stock Shares Shares Shares
100 12/03/08 34.48 2.9 2.9 99.99
100 01/23/09 6.24 16.03 18.93 118.1
100 05/01/09 8.7 11.49 30.42 264.65
100 10/30/09 14.58 6.86 37.28 543.52
400 01/02/10 15.06 37.28 37.28 561.42

This would be about a 40% return on my investment!

However, if you were to buy everything on the initial purchase date, you would have been down by more than 40%!  This is the power of dollar cost averaging!  If you mess up and buy at a bad time, you have an opportunity of averaging out the cost by buying in small chunks instead of one lump some.

One of the most famous dollar cost averaging devices is your company 401(k) plan.  The typically company 401(k) plans purchase mutual fund or ETF shares in biweekly or monthly allotments.  This is powerful because it takes some of the gambling aspect out of investing by enabling you to spread the risk out over time.

Another beautiful aspect of dollar cost averaging is that it takes advantage of sudden deep dips in the stock market, enabling you to buy shares cheaply!  In the chart above, you see on 05/01/09, I was able to buy XYZ shares at the $8.70.  At $8.70 I was able to buy 11.49 shares instead of the 2.9 shares that I would have bought on 12/03/08.  When the share price recovered, I got a big boost in the value in my portfolio!  Brilliant!

This is why I don’t mind seeing temporary dips in the market for a month to two!

Okay, now let’s talk about if you have a large amount to invest… 

If I had $100,000 (or even $5,000), I’m not going to stuff it under my mattress or have it sit around doing nothing waiting until I can Dollar Cost Average it!

While your money is waiting to be invested, it need to be invested! Confused?  Yeah, I wrote it that way on purpose, sorry (mauhaha)…  What I mean is you need it invested the large amount in CDs, Bonds or some highly liquid (or at least safe) investment so that it at a minimum the value of the money keeps up with inflation (or tries too).  Mostly this paragraph is moot though, since the money you’re investing mostly comes from wages that you’ll be investing into dollar-cost averaging devices.

Do you use dollar cost averaging and if not, what technique do you use?

 

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