How Dollar Cost Averaging Works

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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.

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.