What is Dollar Cost Averaging?

Dollar cost averaging (DCA) is a very powerful investment strategy. It takes the form of investing equal amounts periodically over specific time periods (such as $50 monthly) in a particular stock, mutual fund, or ETF. The premise behind it could even be applied to non-investment securities because it isn't dependent on the quality of the investment, but more on the fluctuations in price from time to time.

Here are the basics of DCA:

1. Invest a fixed amount of money each period. This amount of money cannot fluctuate.
2. Purchase one particular asset type. This could be a mutual fund, stock, bond, ETF, commodity, or even a non-investment product such as groceries. Yes, I said groceries.
3. Purchase your items a regular schedule regardless of market fluctuations.

Here's an example. Every week, you may go to the grocery store with a specific list of items. Most likely, your list includes some type of lunch item. For me, this would be frozen meals. Prices on these meals could fluctuate from $1.50 to $3.00 per meal depending on the promotions, supply, demand, and other factors. Let's say instead of buying five meals per week, instead, you purchase $12 worth and store excess in your freezer at home.

Week 1: Price $1.50 per meal. $12 buys 8 meals.
Week 2: Price $2.00 per meal. $12 buys 6 meals.
Week 3: Price $3.00 per meal. $12 buys 4 meals.
Week 4: Price $3.00 per meal. $12 buys 4 meals.
Week 5: Price $3.00 per meal. $12 buys 4 meals.
Week 6: Price $3.00 per meal. $12 buys 4 meals.

In the above strategy, 30 meals were purchased over a period of 6 weeks, but because a DCA strategy was used, the total cost was $12 times 6, or $72. However, if five meals were purchased each week, regardless of the price, then $77.50 would be the final cost (5 meals times the current price each week). So, the DCA strategy actually saves $5.50.

Now, if you apply this strategy of purchasing to something like a mutual fund, you will see that DCA actually lowers your basis in the investment. If you invest in a 401k on a regular basis, you are already doing this.

Personally, when I invest in a stock investment, I try to spread out my purchases over a period of time and ease my way into the security. In this way, I can average down, as if applying a DCA strategy.

Let's see this strategy in action for General Electric stock. Here are the closing prices for GE stock in during three randomly chosen weeks.

Dec 28, 2009 - $15.13
Jan 4, 2010 - $16.60
Jan 11, 2010 - $16.44

Each week, we buy $1,000 worth of stock (paying a $9.99 commission). What is the effect of DCA?

Shares purchased (rounded down, whole shares only):

Dec 28, 2009 - 65 shares (($1000-$9.99)/$15.13)
Jan 4, 2010 - 59 shares (($1000-$9.99)/$16.60)
Jan 11, 2010 - 60 shares (($1000-$9.99)/$16.44)

During this three-week period, $2,949.25 was invested in 184 shares of stock, with $29.97 in commissions paid, and $20.78 in cash left over ($3,000 total). At the end of the period, this account would be worth $3,045.74 ($3,024.96 in stock and $20.78 cash). $45.74 would be considered a profit.

Notice the DCA strategy works when prices are rising and falling (as long as the overall trend is up). And even larger commissions can be negated by the fact that you are loading up on cheap shares when the prices fall.

Disclaimer: This post is not an endorsement of any particular stock or security.