Financial Foundations: Dollar Cost Averaging
Hi! I’m Nick, and welcome to Financial Foundations. I’m going to cover several concepts of investing that may seem confusing and show you that they’re actually simpler than you think. Let’s talk about Dollar Cost Averaging.
Dollar cost averaging is an investment technique where people purchase shares of a company or mutual fund on a regular basis, investing the same amount of money each month, regardless of the price of the shares you are buying. So, why would you do this? Well, here are two reasons.
One, you don’t have a large lump sum of money to invest, but you can save some money on a monthly basis.
And two, you may be fearful of a significant decline in the shares you wish to buy. Dollar cost averaging helps reduce the risk of investing, assuming that in the long run the price of the shares you buy will eventually go up.
Let’s look an example. Let’s say that you have $12,000 and want to invest that money into just one company… Nick Corp! If you were to invest that entire amount of money today, and each Nick Corp share costs $10, you would own 1,200 shares.
Now with dollar cost averaging, instead of investing the entire $12,000 at one time, you’re going to split that money up and only invest $1,000 each month for 12 months. Let’s assume that Nick Corp’s share price goes down every month for the first 6 months, and then goes back up to $10 by the end of the 12 months.
So, investing $1,000 in month 1 at $10 per share buys you 100 shares. In month 2, let’s say that the price per share is $9, so you purchase 111 shares. In month 3, let’s say the price is $8, so you buy 125 shares. 143 shares at $7 in month 4, 167 at $6 in month 5, and 200 at $5 in month 6.
In this extreme example, you would own 1,692 shares instead of only 1,200 shares, assuming that Nick Corp’s share price goes up by $1 in each of the next 6 months, back up to $10 by the end of month 12.
That’s one of the advantages of dollar cost averaging! Instead of seeing your money go down right after investing a large lump sum, you can hopefully feel better knowing that you are purchasing more shares each month that the price goes down. However, it’s really important that you invest the same amount of money each month regardless of the ups and downs in market pricing.
However, in order for dollar cost averaging to work properly and most successfully, the share price of the company must rise after its price declines. Otherwise, you could still end up losing some money on your investment. So, to ensure a good investment, it’s important that you diversify your money by owning several different companies.
There you go! You now know how dollar cost averaging works. I’m Nick and thanks for joining me on Financial Foundations. See you next time!