Dollar cost averaging is an investment technique that, in theory, mitigates the risk of investing a lump sum of money into the market all at once. Essentially DCA (dollar cost averaging) is a schedule for investing a set amount of money at regular intervals without paying attention to the price of the security.

 

Say you have twelve thousand dollars to invest and a great company in your sites, instead of purchasing as much of the stock as possible with the twelve thousand you could alternatively invest one thousand dollars each month for one year, thereby investing all of the money. The theory supposes that stock fluctuations make it difficult for the average investor to know the best time to invest. Moreover by investing at periodic intervals you are more likely to invest at an average price, overall, rather than investing unintentionally at its peak and then suffering the losses of purchasing an overvalued stock.

 

 

The table below charts the value of the iShares CDN S&P/TSX MidCap Index Fund from May 5th 2006 to May 2007

 

DateOpenHighLowCloseVolume
5-May-0685.986.1584.6985.573011
12-May-0685.6986.583.7483.870729
19-May-0682.8882.9779.279.92486234
26-May-0680.0581.579.3581.5112051
2-Jun-0681.9282.7481.6882.7441895
9-Jun-0683.1283.1278.1579.62106091
16-Jun-0679.6179.6275.5478.21212805
23-Jun-0677.878.4276.0378.35108934
30-Jun-0678.3580.6778.2880.48194336
7-Jul-0680.8481.0279.1779.2272651
14-Jul-0679.0680.8278.979.0579959
21-Jul-0679.279.277.377.3175191
28-Jul-0677.9580.877.5880.5571393
4-Aug-0680.3582.0680.3581.81117360
11-Aug-0681.9482.6581.1281.45111569
18-Aug-0681.1282.2980.6682.2252660
25-Aug-0682.4684.0282.4682.961342
1-Sep-0682.5584.2782.0584.1740843
8-Sep-0684.4284.4282.3982.698620
15-Sep-0681.7882.3781.1281.6862369
22-Sep-0681.4881.9180.0780.2951669
29-Sep-0680.2280.6679.18079713
6-Oct-0680.2580.2577.5978.94120060
13-Oct-0678.8980.3478.8980.3420864
20-Oct-0680.6781.980.681.53207245
27-Oct-0682.378482.283.49261453
3-Nov-0683.0783.7980.0681.24234569
10-Nov-0682.1583.182.0682.5958311
17-Nov-0682.4383.8881.9583.42169427
24-Nov-0683.4485.5983.4485.38139980
1-Dec-0685.3986.3184.4485.6575877
8-Dec-0686.0587.285.8587.218705
15-Dec-0686.9887.786.5287.330100
22-Dec-0687.1187.2385.4185.6943745
29-Dec-0685.5986.9185.5986.9115369
5-Jan-0786.7887.2383.2683.58282582
12-Jan-0783.8985.8783.685.78169967
19-Jan-0786.287.1785.8586.39109153
26-Jan-0786.588.8586.588.42155887
2-Feb-0788.3390.1988.1890.1950705
9-Feb-0790.19190.190.5147093
16-Feb-0790.5191.569091.3527755
23-Feb-0791.5592.290.9592.0434358
2-Mar-0792.5592.5588.8888.98245319
9-Mar-078890.2287.6789.72381499
16-Mar-0789.789.787.287.69369471
23-Mar-0788.3590.8488.1590.84214349
30-Mar-0791.3591.3590.0790.1283542
5-Apr-0789.9591.8889.9591.73145478
13-Apr-079292.6791.4292.6733648
20-Apr-0792.793.7592.2393.45402711
27-Apr-0793.3593.792.6393.3557577
4-May-0793.595.2591.894.89104705

In this example we will invest the thousand dollars as close to the beginning of the month as possible. If you were able to purchase the shares for the price they opened at the beginning of each month you would own:

 

MonthAmount investedPurchase PriceAmount of Shares
6-May$1,000.00$85.9011.64
6-Jun$1,000.00$81.9212.21
6-Jul$1,000.00$80.8412.37
6-Aug$1,000.00$80.3512.45
6-Sep$1,000.00$82.5512.11
6-Oct$1,000.00$80.2512.46
6-Nov$1,000.00$83.0712.04
6-Dec$1,000.00$85.3911.71
7-Jan$1,000.00$86.7811.52
7-Feb$1,000.00$88.3311.32
7-Mar$1,000.00$92.5510.8
7-Apr$1,000.00$89.9511.12
Total Shares=141.75
Total Invested=$12,000.00
Value of investment=$13,254.08

 

Now had you invested all of your money on May 5th 2006 here is what you would have ended up with by May 4th 2007:

 

MonthAmount investedPurchase PriceAmount of Shares
6-May$12,000.00$85.90139.7
Total Shares=139.7
Total Invested=$12,000.00
Value of investment=$13,061.95

 

By using dollar cost averaging you would have in turn profited an extra $192.13 or 10.45% as opposed to 8.85%.

 

As with any theory there are proponents and critics of dollar cost averaging, critics label it a lazy way to invest. They maintain that there are certain periods when no one should invest in the market. Moreover critics believe that by simple observation, such as when stocks fall below there 200 day moving average you can select a better time to invest rather then letting the calendar choose for you. This brings me to my point about selecting what type of security to invest in if you decide to dollar cost average.

 

You will notice the name of the stock I chose is more like a stock index then a share that is traded. It is an ETF. ETFs are designed to mimic different indexes of major exchanges such as the S&P/TSX Completion Index or DJIA. They are less volatile by nature and charge lower management fees than mutual funds. Generally there will be less volatility in an index then in high-risk securities because they are diversified holding many stocks from a given sector. Index funds will be covered in a different tutorial. But until then remember that dollar cost averaging is a tool to be used, but only in conjunction with securities that are not prone to wild fluctuations and not during periods of extreme speculation.

 

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