What is dollar cost averaging?
When an investor buys the same stock or mutual fund at regular intervals and with a fixed amount, he or she is said to be using the dollar cost averaging method. If the market price of the selected stock or mutual fund declines, the investor will buy a greater number of shares.
On the other hand, when the market price of the selected stock or mutual fund increases, the investor will buy lesser number of shares. This investing strategy will, over a period of time, result in the investor buying the selected stock or mutual fund at an average cost per share that will be less than the average price per share.
Example:
Assume that a person invests $100 per month for 12 months in Sun mutual fund:
|
Month |
Dollars |
Price per |
No. of shares |
|
Invested |
share |
purchased |
|
|
|
|
|
|
|
January |
100 |
12.76 |
7.84 |
|
February |
100 |
13.25 |
7.55 |
|
March |
100 |
15.25 |
6.56 |
|
April |
100 |
18.76 |
5.33 |
|
May |
100 |
20.26 |
4.94 |
|
June |
100 |
18.85 |
5.31 |
|
July |
100 |
15.62 |
6.40 |
|
August |
100 |
17.85 |
5.60 |
|
September |
100 |
16.62 |
6.02 |
|
October |
100 |
13.26 |
7.54 |
|
November |
100 |
14.5 |
6.90 |
|
December |
100 |
16.76 |
5.97 |
|
Total |
1,200 |
193.74 |
75.94 |
|
|
|
|
|
|
Average price per share = 193.74/12 = $ 16.15 |
|||
|
Average cost per share = 1,200/75.94 = $ 15.80 |
|||
As you can see from the above table, the average cost per share is lower than the average price per share.
Benefits of dollar cost averaging
1) It encourages automatic savings by permitting systematic contributions to an investment portfolio. You can agree with the fund to withdraw funds periodically from your bank account and invest it in the fund automatically.
2) You can reduce some of the risk that poor timing and potentially adverse price fluctuations will have on your investment decisions.
Drawbacks of dollar cost averaging
1) Dollar cost averaging will not protect you in a steadily declining market.
2) If you discontinue with a dollar cost averaging plan, you will lose money when the market value is less than cost of the shares.
Information is for educational and informational purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.
