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Dollar cost averaging: The full breakdown

At a glance:

  • How dollar cost averaging works

  • Formula for calculating price per share

  • Summary of dollar cost averaging

  • Practical ideas you can start with today

Dollar cost averaging is an investment strategy that evens out the fluctuations in the price of an investment purchased over time. It works by investing the same dollar amount in a security at regular intervals. This strategy is most commonly used to purchase mutual fund shares on a regular basis.

How dollar cost averaging works

First, let's define the term.

What is dollar cost averaging?

Dollar cost averaging is the practice of purchasing the same dollar amount of shares of an investment each period of time. When the price of the investment is up, you buy fewer shares. When the price is down, you buy more shares. To turn this practice into habit, it can be helpful to make the payments on the same day each period.

This differs from buying the same number of shares each time.

Trader Joseph Lawler works on the floor of the New York Stock Exchange, Monday, March 18, 2019. (Photo: AP Photo/Richard Drew)
Trader Joseph Lawler works on the floor of the New York Stock Exchange, Monday, March 18, 2019. (Photo: AP Photo/Richard Drew)

How share averaging works

Let us explain this with an example.

Imagine instead of dollar cost averaging that you chose to buy 100 shares on the 15th day of every month for four consecutive months. This is share averaging. Assume the share prices were the following on the 15ths of these months:

By dividing the total amount you paid ($2,200) by the number of shares you purchased (400), you find that the average price is $5.50 per share.

Now let's look at buying the same dollar amount of shares.

Buying dollar amounts

If you invest the same amount of money as the previous example over four months, you would invest $550 on the 15th of each month. You get the following:

You purchased 485.833 shares with your total investment of $2,200. By dividing $2,200 by 485.833, you arrive at an average price of $4.53 per share. This is a savings of 97 cents per share from the $5.50 per share in the previous example. You purchased more shares for the same investment. Great job!

You can see that when prices are low, you can buy more shares. Conversely, when prices are high, you will buy fewer shares. Thus, when it comes time to receive dividends, you should have more shares on which you can potentially earn dividends.

Formula for calculating price per share

With the following handy formula, you can compare what you would have paid per share using different investment strategies. This is the formula used to compare the results of buying a fixed number of shares per month to purchasing a fixed dollar amount of shares per month.

Price per share

You can determine your average price per share (what you paid) with this formula:

If you purchased the same number of shares of an investment each month over several months, you would pay more per share than if you had invested that same total amount of money divided equally over the same number of months. The reason? You would actually buy more shares using the dollar cost averaging method.

What it boils down to

Dollar cost averaging is a method of investing that may help reduce the risks of market timing by investing a fixed amount at regular intervals. When prices are low, your investment purchases more shares.

When prices rise, you purchase fewer shares. Over time, the average cost of your shares will usually be lower than the average price of those shares. It does not assure a profit or protect against losses in a declining market. However, over longer periods of time it can be an effective means of accumulating shares. Investors should consider their ability to continue investing through periods of low market prices.

Summary of dollar cost averaging

Dollar cost averaging is a simple and straightforward method of investing. It is often an option for the investor who wants to systematically contribute to his or her investment portfolio over time. By electing to dollar cost average, you may reduce some of the risk that poor timing and potentially adverse price fluctuations will have on your investment decisions.

Dollar cost averaging works because you invest the same amount of money each period so you buy more shares when the price is low and fewer of the more expensive shares. In this way, you average the price you pay for shares of your investment.

Practical ideas you can start with today

  • Use dollar cost averaging as part of my regular savings plan to even out the cost of my stock or mutual fund investments.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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