Friday Financial Tidbit-What is dollar cost averaging?

If you have ever watched the shows on MSNBC, Bloomberg, or Fox Business that have the investing gurus you have probably heard the term “Dollar cost averaging” at some point. Personally, I have heard the term before but never really knew what it was fully until I learned about some of the theory behind it.

Dollar cost averaging is an investment strategy used by many investors. Its goal is to lower the average cost per share on your investments. You do this by buying the same dollar amount of funds at regular intervals over time.  Below is an example I have created outlining how dollar cost averaging works during three different market scenarios: declining market, steady market, and rising market.

Declining Market
Amount Price per share Shares purchased
 $   100.00  $           10.00                   10.00
 $   100.00  $            9.00                   11.11
 $   100.00  $            8.75                   11.43
 $   100.00  $            8.50                   11.76
 $   100.00  $            7.50                   13.33
 $   100.00  $            6.75                   14.81
Total  $   600.00  $           50.50                   72.45
Average price paid per share: 50.5/6=$8.42
Dollar cost averaging per share: $600/72.45=$8.28
Steady Market
Amount Price per share Shares purchased
 $   100.00  $           10.00                   10.00
 $   100.00  $           10.10                    9.90
 $   100.00  $           10.00                   10.00
 $   100.00  $            9.95                   10.05
 $   100.00  $           10.15                    9.85
 $   100.00  $           10.05                    9.95
 Total   $   600.00  $           60.25  $               59.75
Average price paid per share: 60.25/6=$10.04
Dollar cost averaging per share: $600/59.75=$10.04
Rising Market
Amount Price per share Shares purchased
 $   100.00  $       10.00                   10.00
 $   100.00  $           10.00                   10.00
 $   100.00  $           10.50                    9.52
 $   100.00  $           11.25                    8.89
 $   100.00  $           12.00                    8.33
 $   100.00  $           13.00                    7.69
 Total  $   600.00  $           66.75  $               54.44
Average price paid per share: 66.75/6=$11.13
Dollar cost averaging per share: $600/54.43=$11.0

As you can see from the examples above the dollar cost averaging price per share is lower than the average price paid per share for both the declining and rising markets. So for the declining markets example you could sell all your shares for anything over $8.28 and still make a profit, even though the average price paid per share is $8.42. For the rising markets, you are buying fewer shares at the higher price and are building some protection against over evaluated stocks. For the steady market there is not much change but you have spread out your investment purchasing and have reduced risk.

Dollar cost averaging is a great way to reduce investment risk as well as to provide a way to slowly ease into investing, especially in down markets. So the next time you hear the term on TV you will know that it is not some complicated investment strategy, but rather a strategy that anyone can employ.

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About Jon White

Giving people hope and seeing them win with their finances is something I have a strong passion for. Because of this passion I started JW’s Financial Coaching in the summer of 2010. Financial coaching has allowed me to combine my passions of finances, teaching, and helping others by helping people get on the right track financially. I'm interested in hearing your story so please do not hesitate to interact with me through social media.
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