Dollar cost averaging (DCA) is a well know investing strategy and a very good long-term investment strategy. I will attempt my best to explain what dollar cost averaging is and the method to calculating dollar cost averaging.
When you set aside a same amount of money to invest regularly (in stocks, mutual funds, for example), you are dollar cost averaging. With dollar cost averaging, you do not care what the current share price of the stock is. In other words, regardless how the market or a particular piece of stock is performing, you are always regularly purchasing one particular investment with the same amount of money.
Usually you would dollar cost average in the frequency of once a month. Overtime, you will have purchased and accumulated a number of shares of that stock. Because you are investing the same set amount of money into that particular piece of stock, each month your purchase price will be different and so will the number of shares that you purchase each month (assuming each month the price of the stock fluctuates). So in some months you will buy at a lower price, some months you will buy at a higher price. This is dollar cost averaging.
So how do you calculate dollar cost averaging? It is quite simple. Have a look at the example scenerio. Imagine you are setting aside $200 a month to invest in a stock. The follow table shows the price of the stock each month for a period of 6 months and the number of shares your $200 a month has purchased:
| month | investment amount | share price | # of shares purchased | # of shares accumulated |
| 1 | $200 | $20 | 10 | 10 |
| 2 | $200 | $12.5 | 16 | 26 |
| 3 | $200 | $10 | 20 | 46 |
| 4 | $200 | $8 | 25 | 71 |
| 5 | $200 | $10 | 20 | 91 |
| 6 | $200 | $12.5 | 16 | 107 |
| total investment: $1200 | average share price: $12.17 |
total value: |
$1337.50 |
As you can see, your first month’s purchase the stock price was at an all time high of $20/share, then the market took a dive and your stock price went down for the next few months. However, because you did dollar cost averaging and you regularly purchased the same stock each month for $200′s worth, when you average the share price (add up all 6 month’s share price, and divide by 6) it is $12.17/share. The $12.17/share represents the average share price, or the price of the stock averaged over 6 moths that you did dollar cost averaging. The mathematical relationship between the average share price and the total accumulated shares is complicated and I will save it for a later post.
So, as you can see, dollar cost average takes the advantage of the fact that your dollar can go a long way (purchase more shares) when the market takes a dive, and as long as the market rebounds above your average share price, you will come out ahead. Please keep in mind that dollar cost average is not to be taken for short-term investment strategy.
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