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What is Dollar Cost Averaging?
Dollar Cost Averaging means bringing down the average purchase price of an investment you already own by buying more of it at lower prices.
For example:
I bought 100 shares of Microsoft at $34.00 a year ago, making my investment in Microsoft $3,400 (100 shares @ 34 = $3,400).
Now, suppose today that the price of Microsoft is just $17.00 and I have $3,400 more to invest. I buy 200 additional shares, increasing my total holdings to 300 shares (200 shares @ 17 = $3,400).
Since my total investment is $6,800, my average purchase price is now only $22.67 (6800 / 300).
The Psychology of Dollar Cost Averaging
In our example, we would look at our Microsoft holdings (before dollar cost averaging), and say – this stocks needs to double its price before I can make any profit on it. However, after dollar cost averaging, the stock needs to go up just 5.67 per share before I start to make money. This is a very heartening feeling, and one I’ve done several times. However, if you are averaging just for this warm feeling, then you need to take a hard look at the opportunity costs.
Opportunity Costs of Dollar Cost Averaging
Opportunity cost is what you forgo in order to get something else (economists call it the value of the next best alternative). For instance, if what I really wanted to do with my second $3,400 was buy Apple stock (trading at $80) instead of Microsoft, the opportunity cost of my decision is the Apple stock. Since $3,400 translates to about 42 Apple shares, the opportunity cost of 200 Microsoft shares is 42 Apple shares.
As long as both Apple and Microsoft grow at the same rate, it doesn’t make any difference to me. It is only when Apple appreciates quicker than Microsoft do I get affected. This is key because stocks that fall tremendously may not rise as much as the rest of the market. The very fact that they fell so much shows that something is wrong with them.
The Only Reason to Dollar Cost Average
There is only one reason that justifies dollar cost averaging.
If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.
Should you Dollar Cost Average?
Next time you are tempted to buy more stock to bring the average cost down, ask yourself one thing. Am I doing this for a warm feeling or is the stock a steal at this price? If you answer this question honestly, you will get it right much more often.
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{ 4 comments… read them below or add one }
Thanks for allowing my post here!
Dollar cost averaging also often refers to buying a constant dollar amount of stocks or bonds at regular intervals – over a period of time you get the average price even if you buy on some of the high or low days. What you describe is more of a one-time thing.
It’s not necessarily that bad to buy a stock that has gone down. If someone is willing to sell it to you for less than its worth you should take it before they realize this, and if you’re willing to buy another stock for more than it’s worth that doesn’t automatically mean it will go up.
In fact, the reverse is usually true. Although a share in a company is only worth what someone will pay for it, the actual value can’t possibly change as much as the price does. This means that sometimes the price is too high and sometimes it’s too low – if it’s risen rapidly there’s a very good chance that it’s too high (or just high enough that you’re already paying full price for the better earnings so it’s not an advantage).
Agree with your premise, particularly in a bear market! While the Warren Buffet’s of the investing world can afford to average down to own large stakes in good companies, the average investor gets killed as they quickly run out of funds to average down further, not to mention picking the wrong stocks to begin with!
The only time it might make sense is during a bull market, in a good stock, after short term pullbacks to technical support (usually the 20 or 30 day moving average). In that case, you’ll be averaging up NOT down. Those pullbacks are good entries that institutional traders use to add to their positions. Let them drive the price and you can just go along for the ride.
@Silicon Prairie – I love the idea of someone buying 100 dollars worth of stock every month regardless of the stock market ups and downs. This is a good way to move away from market timing that can prove dangerous.
@Stephen – I’ve done upwards averaging myself. Most of the time I have not regretted it, but of course like everything else – I’ve made mistakes in this too.
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