Dollar cost averaging is a simple method of investing a specific amount of money at specific periods of time without consideration for the cost. For example; you decide to take $100 a week out of your paycheck and have it automatically set aside to fund the purchase of a stock or bond each week. For the sake of simplicity, the stock originally sold for $20 per share so each week you were initially able to purchase 5 shares. Later the stock price increased to $25 per share so now you can only purchase 4 shares. Notice, the number of shares has declined but the original value of the first shares increased.
|Month 1||Month 2|
|5 shares at $20 = $100||5 shares worth $25 = $125|
The rationale is that buy purchasing at a steady rate, you will benefit from the increases while negating the decreases. But does it actually work? According to a landmark bit of research conducted by the Journal of Financial & Quantitative Analysis in 1979…No, it doesn’t measure up to lump sum investing when comparing total return. Statistically speaking the overall rate of return was less for dollar cost averaging. On the other hand, dollar cost averaging does provide a return – just not quite as high as that of lump sum investing. It is also a valuable way to begin investing especially for new investors.
Hereafter, the typical cost per share of the security will come to be smaller and smaller. Dollar cost averaging decreases the chance of investing a big amount in an individual investment at the incorrect time. For example, you decide to buy $100 worth of XYZ every month for three months. In January, XYZ is worth $33, so you purchase three shares. In February, XYZ is worth $25, so you purchase four extra shares this time. Finally in March, XYZ is worth $20, so you purchase five shares. Totally, you bought 12 shares for an medium price of approximately $25 each.