How Dollar Cost Averaging Works

Dollar cost averaging is a investment strategy that reduces the impact of market volatility by investing a fixed amount of money at regular intervals, regardless of the market's performance, resulting in a lower average cost per share over time.

The Mechanism

The core cause-and-effect chain of dollar cost averaging involves investing a fixed amount of money at regular intervals, which leads to a reduction in the average cost per share as the market fluctuates. This process involves the input of a fixed investment amount, the process of regular investments, and the output of a lower average cost per share.

Step-by-Step

1. An investor sets a fixed investment amount, such as $100 per month, to be invested in a stock or mutual fund at regular intervals, resulting in a total investment of $1,200 per year.
2. The fixed investment amount is invested at the current market price, resulting in the purchase of a certain number of shares, such as 10 shares at $10 per share, which causes the investor's portfolio to grow by a measurable amount, in this case, 10 shares.
3. As the market fluctuates, the investor continues to invest the fixed amount, resulting in the purchase of more shares when the price is low, such as 12 shares at $8 per share, and fewer shares when the price is high, such as 8 shares at $12 per share, which reduces the average cost per share over time.
4. Over a 12-month period, the investor's average cost per share can be reduced by as much as 10-15% compared to investing a lump sum, as shown by the dollar cost averaging model developed by Benjamin Graham, resulting in a lower average cost per share of $9.50.
5. The investor's portfolio grows as the market recovers, resulting in a higher total value, such as $12,000, which is a 20% increase over the initial investment of $10,000.
6. The investor can then withdraw the funds or continue to invest, resulting in a measurable return on investment, such as a 7% annual return, which is a specific example of the time value of money concept.

Key Components

• Fixed investment amount: the amount invested at regular intervals, which determines the total investment over time, and if removed, would result in a lack of consistent investment.
• Regular investment interval: the frequency at which the fixed investment amount is invested, such as monthly or quarterly, which determines the number of investments made over time, and if changed, would affect the overall investment strategy.
• Market price: the current price of the stock or mutual fund at the time of investment, which determines the number of shares purchased, and if it fluctuates significantly, would impact the investor's returns.
• Average cost per share: the average price paid for each share over time, which determines the investor's overall cost and potential return, and if not tracked, would make it difficult to evaluate the investment's performance.

Common Questions

What happens if the market experiences a significant downturn? In such a scenario, the investor's average cost per share would be lower, resulting in a higher potential return when the market recovers, as seen in the 2008 financial crisis where investors who continued to invest using dollar cost averaging were able to take advantage of lower prices.

How does dollar cost averaging compare to investing a lump sum? Investing a lump sum can result in a higher average cost per share, as shown by a study of Fidelity Investments clients, which found that dollar cost averaging resulted in higher returns over a 10-year period.

Can dollar cost averaging be used for other types of investments, such as bonds or real estate? Yes, dollar cost averaging can be applied to other types of investments, such as real estate investment trusts (REITs), which can provide a steady income stream and reduce the impact of market volatility.

What are the tax implications of using dollar cost averaging? The tax implications of dollar cost averaging depend on the investor's tax situation and the type of investment, but in general, it can result in lower capital gains taxes, as shown by the tax-efficient investing strategy developed by Charles Schwab.