Dollar cost averaging is a technique designed to reduce market risk through the systematic purchase of securities at predetermined intervals and set amounts. Many successful investors already practice without realizing it. Many others could save themselves a lot of time, effort and money by beginning a plan. In this article, you will learn the three steps to beginning a dollar cost averaging plan, look at concrete examples of how it can lower an investor’s cost basis, and discover how it reduces risk.
Dollar Cost Averaging: What is It?
Instead of investing assets in a lump sum, the investor works his way into a position by slowly buying smaller amounts over a longer period of time. This spreads the cost basis out over several years, providing insulation against changes in market price.
Setting Up Your Own Dollar Cost Averaging Plan
In order to begin a dollar cost averaging plan, you must do three things:
1. Decide exactly how much money you can invest each month. Make certain that you are financially capable of keeping the amount consistent; otherwise the plan will not be as effective.
2. Select an investment (index funds are particularly appropriate, but we will get to that in a moment) that you want to hold for the long term, preferably five to ten years or longer.
3. At regular intervals (weekly, monthly or quarterly works best), invest that money into the security you’ve chosen. If your broker offers it, set up an automatic withdrawal plan so the process becomes automated.
An Example of a Dollar Cost Averaging Plan
You have $15,000 you want to invest in Sprint FON common stock. The date is January 1, 2000. You have two options: you can invest the money as a lump sum now, walk away and forget about it, or you can set up a dollar cost averaging plan and ease your way into the stock. You opt for the latter and decide to invest $1,250 each quarter for three years. (See chart for math of dollar cost averaging plan.)
Had you invested your $15,000 in January 2000, you would have purchased 264.46 shares at $56.72 each. When the stock closed for the year in December of 2002 at $13.69, your holdings would only be worth $3,620!
Had you dollar cost averaged into the stock over the past three years, however, you would own 746.21 shares; at the closing price, this gives your holdings a market value of $10,216. Although still a loss, Sprint FON stock must only go up to $20.10 for you to break even, not $56.72, which would have been required without the dollar cost averaging.
To go a step further, without dollar cost averaging you would break even at $56.72. With dollar cost averaging, you would have turned a profit of $27,326 when the stock hit that price thanks to your lower cost basis ($56.72 sell price – $20.10 average cost basis = $36.62 profit x 746.21 shares = $27,326 total profit.)
Combining the Power of Dollar Cost Averaging with the Diversification of a Mutual Fund
Index funds are passively managed mutual funds that are designed to mimic the returns of benchmarks such as the S&P 500, the Dow Jones Industrial Average, etc. An investor that puts money into a fund designed to mimic the Wilshire 5000, for example, is literally going to own a fractional interest in every one of the five thousand stocks that make up that index. This instant diversification comes with the added bonus. Traditionally, management fees of passive funds are less than one-tenth those of their actively managed counterparts. Over the course of a decade, for example, this can add up to tens of thousands of dollars the investor would have paid in fees to the mutual fund company that, instead, are accruing to his or her benefit.
The dollar cost averaging component reduces market risk, while the index fund investment reduces company-specific risk. This combination can be among the best investment options for individuals looking to build up their long term wealth by having a portion of their portfolio in equities.
Table 1: Sprint FON with Dollar Cost Averaging Plan
Invest date Amount Price per share Shares purchased
Jan. 2000 $1,250 $56.72 22.04
Apr. 2000 $1,250 $54.19 23.07
Jul. 2000 $1,250 $31.34 39.27
Oct. 2000 $1,250 $22.60 53.31
Jan. 2001 $1,250 $22.10 56.50
Apr. 2001 $1,250 $19.05 65.62
Oct. 2001 $1,250 $18.13 68.95
Jan. 2002 $1,250 $16.14 77.45
Apr. 2002 $1,250 $14.58 85.73
Jul. 2002 $1,250 $8.66 144.34
Oct. 2002 $1,250 $11.64 107.39
Total $15,000 $20.10 avg. 746.21 shares owne