Dollar Cost Averaging

This page is my attempt to illustrate the value of Dollar Cost Averaging (DCA) and how it works in an investor's favor. What is DCA? In case you don't know, it is the idea that investing over time outperforms lump sum investing the majority of the time. The advantage of DCA is that you end up paying less, on average, for whatever it is that you are buying. For my example I will assume a simplified investment in stock (ignoring commissions) but this information can be equally applied to an investment in mutual funds or anything else that has a fluctuating price. Four different scenarios that cover all possible price changes will be examined. The amount invested for each time period will be held at a constant $100 for all scenarios.

I use two abbreviations on this page. DCA simply stands for Dollar Cost Averaging. PPS stands for Price-Per-Share (a computed average of price).

In the first scenario, consider a price that steadily rises through time. That is shown in the following example:

The average PPS for all time periods can be computed by dividing the total of the Price-per-share: column ($15) by the number of time periods (5). Thus, the average PPS is $15 / 5 which is $3. Now lets compute the average paid PPS. That can be obtained by dividing the total cost of the shares ($500) by the total number of shares purchased (228 1/3). Thus, the average paid PPS is $500 / 228 1/3 which is approximately $2.19. See how, by investing using DCA, one would have saved $.81 ($3 - $2.19) per share purchased compared with the average PPS? DCA would have saved money! Additionally, if an investor were to sell now he/she would get back $1141.67 which would be a profit of $641.67 (228 1/3 shares owned * $5 current price = $1141.67 - the $500 original investment = $641.67). He/she would have made less if he/she had put the entire $500 in during any of the last 3 periods and only would have done better by putting it all in during one of the first two periods. The odds of correctly guessing to invest during these first two periods are 2:5 or 40%. Increase the number of time periods and these odds get worse. However, the odds favor an investor who uses DCA and consequently purchases a large number of shares when prices are low and only a few when prices are high.

Next, consider a price that steadily falls through time. That is illustrated as follows:

Since the totals are exactly the same as the first example one can reach some of the same conclusions. Buying like this and depending on DCA would once again have saved $.81 ($3 - $2.19) per share purchased compared with the average price of the shares! Granted, if an investor were to now sell his/her shares he/she would incur a loss of $271.67 ($500 invested - (228 1/3 shares owned * $1 current price)). But, in order to break even, all he/she would need is for the price to go back up to the average PPS paid ($2.19) instead of having to wait for the price to climb higher to the average PPS of $3! If one had invested the full $500 during one of the first 3 time periods that person would be worse off than a person who depended on DCA. Only by putting the full $500 in during one of the last two periods would an investor be better off than he/she would be by using DCA. Even so, the best that investor could have done would be to have broken even. Forget market timing! Your odds are greatly improved by investing over time using DCA rather than by trying to outguess the market.

Now let's examine a price that rises then later falls which is demonstrated below:

Once again, let's first compute the average PPS across all time periods. The total of the Price-per-share: column is $13. When we divide that by the number of time periods (5) we get an average PPS of $2.60. Now lets see how much was paid, on average for each share. The total paid/invested was $500 which ended up buying 286 2/3 shares so the average price is $500 / 286 2/3, or $1.74. Once again, DCA has saved money but in the amount of $.86 per share ($2.60 - $1.74) compared with the average PPS. As with the constantly falling price scenario an investor who had followed this particular plan would incur a loss if he/she were to sell all shares now but he/she would only need the price to go up $.74 to break even. If that investor had spent the entire $500 at once in the 2nd, 3rd, or 4th time period he/she would have been even worse off and lost even more than an investor who had used DCA. An investor who had invested it all in the 1st or 5th period would still only be able to break even.

Finally, let's examine a price that falls then later rises.

To compute the average PPS across all time periods we take the total of the Price-per-share: column ($17) and divide it by the number of time periods (5) to get an average price of $3.40. Now lets see how much was paid, on average for each share. A total of $500 was paid and that ended up purchasing 206 2/3 shares so the average price is $500 / 206 2/3, or $2.42. As in all other scenarios, DCA has saved money (in this scenario $.98 per share). This time, if an investor were to sell, he/she would get a return of $533.33 (206 2/3 shares owned * $5 current price - $500 invested). As with all other scenarios, the odds were against that investor if he/she had invested the entire $500 at once. He/she could only have beaten the performance obtained by DCA if he/she had invested the entire $500 in the 3rd time period.

In summary, Dollar Cost Averaging is a wise method to use when investing. The odds are against an investor who tries to time the market and make lump sum purchases. By using DCA that investor can turn those odds in his/her favor. The key reason for this is that for the same investment, many shares are purchased when prices are low yet, when prices are high, the investment buys only a few shares. Over time, the net result is that an investor repeatedly takes advantage of low prices and has the adverse affect of high prices mitigated. Regardless of how a price moves, DCA always enables you to pay less than the average price of an investment over time. Of course, DCA isn't a cure all and doesn't guarantee success. As with the lump sum investment method, an investor still loses if the investment vehicle he/she chooses drops in price and decreases in value. But DCA will still help that investor out in such an unfortunate event. DCA minimizes the negative effect felt by an investor whose investment drops in value because of the built-in feature of a lower PPS than the average PPS. So set up an automatic monthly or weekly investment whenever possible and you will greatly improve your chances of investment success.