Summary: Dollar Cost Averaging involves making small, regular investments over a long period of time. Dollar Cost Averaging helps to lower an investor’s overall purchase price of a stock, as well as minimize the risks associated with market psychology – including market-timing and panic buying/selling.
One of the most noted advantages of investing with DRiPs is that they are conducive to implementing investment strategies that take advantage of dollar cost averaging. Dollar cost averaging is a fairly simple, yet effective, investing strategy that involves making numerous small purchases of stock over a long period of time rather than investing in one lump-sum. An investor implementing this strategy would invest a certain amount of money into their investment portfolios at regular weekly, monthly or quarterly intervals. By investing a specific amount of money at pre-determined intervals, the investor is able to reduce the risk inherent in investing, because his regular investment purchases more shares of stock in a company when that company’s stock price is low and fewer shares of stock in that company when its stock price is high. While this seems to be a “common-sense approach” to investing, many investors who don’t utilize the dollar cost averaging approach to investing will ultimately fall victim to market psychology. These investors will typically succumb to panic buying or selling and, therefore, generally buy when prices are higher and sell when prices are lower. This is not the way to build a successful portfolio and dollar cost averaging helps to minimize these risks.
Dollar Cost Averaging By the Numbers
Let’s take a look at an example of dollar cost averaging in action and how this strategy can help lower your overall costs when purchasing a stock.
First, consider an investor who is interested in purchasing $1,200 worth of AT&T stock for his portfolio. He has two options: 1) Invest a lump-sum ($1,200) in AT&T stock on May 1 when the stock price is $32.27 or 2) Invest $100 per month each month for 12 months (dollar cost averaging).
Under his first option, it is easy to see that his $1,200 lump-sum investment will purchase 37.2 shares of AT&T stock ($1,200 divided by $32.27). Therefore his average purchase price is $32.27.
Under his second option, or dollar cost averaging, the calculations are slightly more involved. Ultimately, however, using actual AT&T stock prices from May 2007 through April 2008, you will see that dollar cost averaging into the stock over the course of 12 months allows the investor to purchase 38.2 shares of AT&T stock at an average price of $31.39. Study the graph below and notice that when the stock price is higher in a particular month, the investor’s $100 monthly investment purchases fewer shares and when the stock price is lower, his investment purchases more shares.
Utilizing the dollar cost averaging approach to investing, this investor’s AT&T shares would end the year 3% higher than if he had utilized option #1. For an investor utilizing a dollar cost averaging strategy, market volatility is your friend.
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