Dollar Cost Averaging

Someone asked the question: What will the stock market do this year?  The answer:  It will fluctuate. 

When the stock market is low or going down it is good to keep “Dollar Cost Averaging” in mind.  The concept of “Dollar Cost Averaging” is that you keep investing the same amount every month (e.g. $100) regardless of whether the stock market is going up or down.  When the stock market is down you buy more shares for the $100 than you buy when the market is up.  The dollar cost averaging investor always does better than the average over time.  The average value will be greater than the average price.

Most people do the opposite.  When stocks go down they stop buying stock.  Dollar Cost Averaging investors keep putting investment money into the market every month and pay no attention to where the stock market is at the moment.  This concept takes advantage of the commonly accepted practice of buying more of an item when it is on sale and less when it is more expensive.  It does make sense.  Most people realize that this is a good idea for every other item they buy except stock.  This doesn’t make sense because when the market goes down  all the stocks are less expensive i.e. they are on sale.  Normal behavior says buy more when something you want is on sale.  Buy less when it is expensive.  Dollar Cost Averaging automatically does this. 

It is like the stock market stopped its rise October 9, 2007 and said,  ”you know, we have been going up for many years now and there are a lot of people out there who did not take advantage of this big rise so let’s take a break from rising for a while, go back down to the level it was several years ago to let all the people who didn’t get in when it was low several years ago time to get in, then we’ll start going back up again.”  How much better does it get than that?  As the stock market goes up to 14,000 (on the Dow) people say, “gee I wish I had invested years ago when the market was at 8000.”  Well the market has now gone to 8000.  People have short memories.

The stock market will go up over time unless the world as we know it is going to come to an end.  If society and the economy come to an end then it won’t matter what you did with your money.  We will all be in the same catastrophe boat together.  If society and the economy are not ready to come to an end then eventually the stock market will recover and come back up like it has always done.  Everyone who bought stock when the price was low, really low and on sale, will make a lot of money.  This is why Warren Buffet invested a lot of money in Goldman Sachs and other companies recently.  Everything is on sale.  The only difference between Warren Buffet and us is he invested $100 million (or was it a billion?), and we invest $100.  But, he was following the same thinking.

Here is an example of why dollar cost averaging makes you money:  You decide to start investing $100 every month.  The price of stock XYZ is $15.  So you invest your $100 and buy 6.666 shares of stock XYZ at $15.  Next month the price goes down to $10 and you invest your $100 again and buy 10 shares of XYZ stock at $10.  The next month the price goes up to $20 and you invest your $100 again and buy 5 shares of XYZ stock at $20.  The next month the price of the stock goes back down to $15.  Have you made any money on your investment?  It is the same price it started at 3 months ago and you bought stock at $20 and at $10 both of which are $5 more or $5 less than the average of $15.  The average value of the stock over the four months is $15 per share.  So apparently you have not made any money or lost any money.

Actually you made 8.3 % on your investment even though the price of the stock is the same as it started out.  He’s how you made 8.3%. 

You invested $300.  You bought 21.666 shares.  Your average cost was $13.85 per share ($300/21.666 shares = $13.8465 per share).  But the average value is $15 per share over the four months (15+10+20+15=60 / 4 = 15). So  15 / 13.85 = 1.083 or 8.3%.

Here is another way to calculate your increase.  You invested $300 ($100 x 3 = $300).  Your investment is now worth $324.99 (21.666 x $15 current value per share = $324.99)    $324.99 / 300 = 1.0833 or 8.3%.

The reason you made money is because you bought more shares when the price was low (10 shares) than you bought when the price was high (5 shares).  You bought more shares when the stock was on sale at $10 per share than you bought when the stock was expensive at $20 per share.  You made a smart decision to keep investing your $100 per month even though the price was going down.  When the price came back up to $15 per share you made more money on the 10 shares you bought at $10 per share (10 x $5 profit per share = $50 profit), than the money you lost on the 5 shares you bought at $20 per share (5 x $5 loss per share = $25 loss).  So your investment of $300 is now worth $324.99 and you made 8.3% on your money.

Mutual Funds are a good way to invest using Dollar Cost Averaging.  By investing in Mutual Funds you are automatically diversified.  You automatically invest in a portfolio of stocks so the risk is spread over many stocks.  You are never invested in one stock.  If you had invested all of your funds in one stock, e.g. Lehman Brothers or Bear Sterns, your investment may have no value now.  Right now is a good demonstration project of why you should not put all of your eggs in one basket.  Mutual Funds automatically take care of this for you.

A fluctuating market is good to the Dollar Cost Averaging investor.  Right now we are in the trough of the cycle.  The Dollar Cost Averaging investor likes troughs.  It gives him/her the opportunity to buy more shares at a lower price.  When the market comes back up all those shares you bought now during the screaming sale, when the Dow was at 8000 or even less, will be worth a lot.

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