What is Dollar Cost Averaging?

Dollar Cost Averaging
Dollar Cost Averaging

Dollar cost averaging, which is also known as a constant dollar plan works out pretty well for most investors. Basically, dollar cost averaging is investing the same dollar amount periodically (usually monthly) into the same investment (typically mutual funds). So, an investor might decide to invest $1,000 per month into Easy Peasy Wildly Erratic Aggressive Growth Fund. We’ll take a 6 month example to see how it works:

Purchase datePrice per shareShares purchased
April 15$18.20$1,000/$18.2054.945 shares
May 15$25.12$1,000/$25.1239.809 shares
June 15$28.55$1,000/$28.5535.026 shares
July 15$30.03$1,000/$30.0333.300 shares
August 15$32.66$1,000/$32.6630.618 shares
September 15$26.78$1,000/$26.7837.341 shares
231.039 total shares

In the 6-month chart above, you can see that the price per share (2nd column) of the fund fluctuated each purchase date. So, if you take the amount invested ($1,000 per month in the sample above) and divide it by the purchase price per share, you can determine the amount of shares purchased (last column). By looking at the last column, you can see why dollar cost averaging works. You’ll notice that the lower the dollar price per share, the more shares purchased. (Notice that the number of shares purchased is brought out to the 3rd decimal place because mutual funds allow you to purchase fractional shares). By purchasing more shares when the price is lower and less shares when the price is higher, your average cost per share ends up lower.

If you were buying the same number of shares each month, your average cost per share would be:

$18.20 + $25.12 + $28.55 + $30.03 + $32.66 + $26.78 = $161.34

$161.34 / 6 months = $26.89 average cost per share

Now, using dollar cost averaging, we can take the $6,000 invested and divide it by the total shares purchased.

$6,000 / 231.039 shares = $25.97 cost per share using dollar cost averaging.

So, just using the above example, you can see the power of using dollar cost averaging when the price is fluctuating as compared to purchasing the same amount of shares periodically. This investor would’ve saved $.92 per share, which when multiplied by the 231.039 shares purchased, comes out to a savings of $212.56. This may seem insignificant because it was only 6 months we were looking at. However, when you start looking at investing over years where the price fluctuates 10s of dollars, your average cost per share could be a few dollars less using dollar cost averaging over purchasing the same amount of shares each month.

Candidates taking the Series 7 (Series 7 Top-Off Exam) or the Series 6 (Series 6 Top-Off Exam) are expected to know and understand dollar cost averaging.

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Happy Investing!