Dollar cost averaging is a strategy where you invest a fixed dollar amount per period over a long time. This type of investing allows equities to be purchased as the market fluctuates. Instead of buying 10 shares of a stock each month, you buy $100 worth of shares each month. When the stock price is down, you receive more shares for your money. When the price is high, you receive fewer shares. In the long run, this should keep your cost per share lower on average.
Let’s put some hypothetical numbers to this example. Once a month, for four months, you invest $100. In January, your investment costs $20 per share, thus you receive five shares. In February, your investment drops to $10 per share. For your $100, you should receive 10 shares. In march, the price increases to $25 per share, and your $100 yields you four shares. In x, the investment costs $20 per share. For your $100, you receive five shares. At the end of the four months, you have invested $400 and hold 24, shares with an average cost basis of $16.66 Per share.
Under the same circumstances, had you committed to purchasing a fixed number of shares per month, you would have paid more per share. In January, 10 shares would cost you $200. In February, 10 shares would cost $100. In March, when shares were at their most expensive, 10 shares would cost you $250. In April, you would again receive 10 shares for $100. Over the course of four months, you would have invested $750 and hold 40 shares with an average cost basis of $18.75 per share.
In a bull market, dollar cost averaging should allow you to keep up with the market. In a bear market, dollar cost averaging should allow you to do better. Essentially, dollar cost averaging takes market timing off the table. Market timing merely allows investors to believe they are getting the best price at the current time. Only time will tell if the best price the market has to offer was truly received by the investor. Very few investors make money while trying to time the market, and most have failed using this strategy. Market conditions are prone to change at any time. Investing consistently does not protect an investor against loss in a declining market; however, dollar cost averaging has shown to be of relative benefit.
Furthermore, consider one of the best decade for the stock market, 1949-1958. If you had invested $10,000 in one lump sum, your total annualized return would have been 20.06 percent. If you had dollar cost averaged $1,000 a year over the course of the decade, your return would have been 19.20 percent. Although dollar cost averaging doesn’t always work out better, in one of the worst decades for the stock market, 1929-1938, a lump sum invested $10,000 would have lost 0.92 percent annually, while dollar cost averaging would have yielded a 7 percent return.