Dollar Cost Averaging Basics

The easiest way to understand dollar cost averaging is with an example.

Example

Consider the following prices in a sideways market:
a) 100-100-100-100-(repeat).
b) 100-150-100-50-(repeat).
c) 100-175-100-25-(repeat).
In all instances, the average price per share is $100.

There is no volatility in case a, some volatility in case b and much volatility in case c.

Details

Consider what happens if you purchase $10000 of stock each year in Years 1 through 4.

Sequence: price=100-100-100-100
Year 1:
Price=$100 per share
Shares purchased=100 shares
Year 2:
Price=$100 per share
Shares purchased=100 shares
Year 3:
Price=$100 per share
Shares purchased=100 shares
Year 4:
Price=$100 per share
Shares purchased=100 shares
Totals:
Average price=$100 per share.
Shares purchased=400.
Total Amount invested=$40000.
Average price per share purchased=$100 per share.

Sequence: price=100-150-100-50
Year 1:
Price=$100 per share
Shares purchased=100 shares
Year 2:
Price=$150 per share
Shares purchased=67 shares
Year 3:
Price=$100 per share
Shares purchased=100 shares
Year 4:
Price=$100 per share
Shares purchased=200 shares
Totals:
Average price=$100 per share.
Shares purchased=467.
Total Amount invested=$40000.
Average price per share purchased=$85.65 per share.

Sequence: price=100-175-100-25
Year 1:
Price=$100 per share
Shares purchased=100 shares
Year 2:
Price=$175 per share
Shares purchased=57 shares
Year 3:
Price=$100 per share
Shares purchased=100 shares
Year 4:
Price=$25 per share
Shares purchased=400 shares
Totals:
Average price=$100 per share.
Shares purchased=657.
Total Amount invested=$40000.
Average price per share purchased=$60.88 per share.

Comparisons

There is no volatility in case a, some volatility in case b and considerable volatility in case c.

If we purchase $10000 of shares each year, the number of shares purchased through year 4 would be 400 in case a, 467 in case b and 657 in case c. The average price per share actually purchased would be $100 per share in case a, $85.65 per share in case b and $60.88 per share in case c.

You purchase many more shares when prices are low than you purchase when prices are high. This lowers the average price per share purchased. Volatility is good when buying.

Similarly, during retirement when making withdrawals, case c requires that you start out with more shares than case b, which requires that you start out with more shares than case a. Volatility is bad when selling.

A strong price trend alters the results.

Have fun.

John Walter Russell
March 15, 2008