Dollar Cost Averaging

Dollar-Cost Averaging Definition

Dollar-cost averaging means investing the same amount of money in an asset (stocks) at periodic intervals irrespective of its price thereby reducing the risk of price volatility in the market.  For example, an investor would invest $100 every month on the first day of the month for five years in a particular mutual fund.

Example

You can download this Dollar Cost Averaging Excel Template here – Dollar Cost Averaging Excel Template

Here is the dollar cost averaging example; let us look into what would happen if we had invested $1000 regularly on the 28th of every month for a given six month period, as shown below.

Dollar Cost Averaging example 1.1

Here we can see the average share price of Apple over the entire period is $181.26. The price rises quite sharply after 26th February 2019 and decreases again after 26th April 2019, indicating moderate volatility. This makes it very difficult for the investor to determine at which date he should invest in Apple. In this case, he makes a periodic investment of $1000 on the 28th of every month as shown below –

DateCloseInvestedNo of Shares Bought
12-28-2018156.2310006.00
1-28-2019156.310006.00
2-28-2019173.1510006.00
3-28-2019188.7210005.00
4-28-2019204.6110005.00
5-28-2019178.2310006.00

Source: Yahoo Finance

Here we can find the number of shares bought by dividing the amount invested of $1000 by the day’s close price. We can easily find the average share price he paid for these investments by using the formula:

Example 1.3
  • Average Price Paid = Total sum invested / Total shares bought
  • = 6000/34
  • = $176.47

There is an alternate approximate formula to calculate the average dollar price which uses the concept of harmonic meanConcept Of Harmonic MeanHarmonic Mean is the reciprocal of the arithmetic mean of the reciprocal of numeric values. This is calculated by dividing the number of values in a given dataset by the sum of every value’s reciprocals. read more:

Example 1.4
  • Dollar Average Price = Number of periods/ ∑(1/Share Price on investment dates)
  •  = 6 / {(1/156.23)+ (1/156.30)+ (1/173.15)+ (1/188.72) + (1/204.61)+ (1/178.23)}
  • = $174.57

The slight difference in the two average values is because we have rounded off the number of shares in the denominator of the first formula to zero decimal  (since share is generally bought in integral numbers) as in $1000 divided by $156.23 (on 28th December 2018) gives 6.4 which we have rounded off to 6 shares. But in the second formula using harmonic meanFormula Using Harmonic MeanHarmonic Mean is the reciprocal of the arithmetic mean of the reciprocal of numeric values. This is calculated by dividing the number of values in a given dataset by the sum of every value’s reciprocals. read more, we have not rounded off the share price, and hence there is a slight difference between the two figures.

In this case, we see that the investor buys at an average cost of $176.47 per share in dollar-cost averaging, which is 3% less than the average price of Apple for the same period. We can also note that the investor bought the least number of shares (five) on the days where the share prices were unusually high.

Benefits

Disadvantages/Limitations

  • The first limitation is that studies have shown that it is better to invest a lump sum amount as it fetches a higher return, in the long run, provided the investor is timing the market correctly. For example, in our case, had the investor put $6000 before 26th January 2019, his average buy price would be much lower than the dollar average price (11% lower to be accurate)
  • Secondly, dollar cost averaging also leads to more transactions (six times in our case), which would significantly add to the transaction costs for the investor if the brokerage fee is high.

Conclusion

With dollar-cost averaging, the investor invests the same amount of money every time, which results in buying more shares when the share price is low and vice versa. However, if the investor has the time and expertise to track the market and make necessary portfolio adjustments, dollar-cost averaging might not be the most optimal method of portfolio management. Dollar-cost averaging is a very simple and convenient method to invest in the market and promotes disciplined investing, which helps an investor to reach his financial goals.

Recommended Articles

This article has been a guide to what is Dollar Cost Averaging and its definition. Here we discuss the practical example to calculate dollar average cost along with its benefits and limitations. You can learn more about accounting from the following articles –