Dollar Cost Averaging Investing Strategy & Examples

What Is Dollar-Cost Averaging?

Dollar-Cost Averaging is an investing strategy commonly used by investors. If you regularly contribute to a retirement fund or your investment portfolio, you automatically use dollar-cost averaging. This regular contribution averages out the overall cost of the investment.

If the stock price decreases over time, the investor will receive more shares for their money, meaning the asset’s average price is decreased.   This averages down the cost per share, promoting a successful investing outcome. If the stock price increases, they get fewer stocks, which increases the overall average cost.

Dollar-Cost Averaging Formula

The formula for calculating the dollar cost average over 3 purchase periods looks like this.

Dollar-Cost Average = ((P * T) + (P * T) + (P * T)) ÷  ∑ T

• P = Stock Price
• T = Number of Shares Purchased.

An even simpler formula for calculating the Dollar Cost Average.

Dollar-Cost Average = Total $ Amount Invested ÷ Total Number of Shares Owned.

Dollar-Cost Averaging During a Bear Market

In stock market terms, stock prices go up, and they go down.  Dollar-Cost Averaging takes advantage of the down period to buy more stock, and as the stock price rises, less stock is purchased for the same amount.

But here is the clever thing.

If you apply the concept of Dollar-Cost Averaging to your investments during a bear market, you can reduce your overall average cost per share.

Dollar-Cost Averaging vs. Lump Sum Example

In this example, we compare investing over 8 time periods versus investing a simple lump sum of money. If the stock’s cost fluctuates downwards but then returns to the same or higher price, you have benefitted from dollar-cost averaging.

The stock price fluctuates around the $10 mark in the table below, spending equal time above the $10 price as below it.

		1 Payment $8,000	8 Payments $1,000
Quarter Purchased	Share Price	Number of Shares	Number of Shares
Q1	$10	800	100
Q2	$9		111.11
Q3	$8		125
Q4	$7		142.86
Q5	$10		100
Q6	$11		90.91
Q7	$12		83.33
Q8	$13		76.92
Total Shares Owned		800	830.13
Share Value Q8		$10,400	$10,791
Total Profit %		+30%	+35%
Average Cost Per Share		$10	$9.64

Table 1: Dollar Cost Averaging Example – Balanced Market

In the example above, the investor has $8,000 to invest in stocks.

Lump-Sum Investment Value = $10,400

The first example is a single payment of $8,000, which buys 800 shares at $10 per share.  At the end of 8 quarters, the total share value is $10,400 – (Share Price in Quarter 8 * 800 shares)

The Dollar-Cost Averaging Investment Value = $10,791

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters.  As you can see, when the share price is lower, the investor gets more shares for each $1,000 invested.

When the share price is $7, the investor receives 142 shares for $1,000.  Also, when the share price is higher at $13, the investor receives only 76.92 shares.

Here we assume the share price distribution is equal across the eight quarters. The dollar-cost average investor has, in the end, received a benefit of $391 (the difference between the share value of $10,400 in example 1 and $10,791 in example 2).

This means the dollar-cost averaging investor has a profit of 35%, and the lump-sum investor has a gain of 30%.  Not only that, but the average share price cost is also $9.64 rather than $10 per share.

So, all things being equal, especially the share price, dollar-cost averaging comes out on top with an improved profit of 3.8%.

 

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Dollar-Cost Averaging Strategy: Declining Stock Price

In this example, we examine the effects of dollar-cost averaging if the asset’s price continues to decline over the period of the investment. The stock price reduces from quarter one at $10 to quarter eight at $8 with the lowest price of $6.

		1 Payment $8,000	8 Payments $1,000
Quarter Purchased	Share Price	Number of Shares	Number of Shares
Q1	$10	800	100
Q2	$9		111.11
Q3	$8		125
Q4	$7		142.86
Q5	$6		166.67
Q6	$6		166.67
Q7	$7		142.86
Q8	$8		125
Total Shares Owned		800	1080.16
Share Value Q8		$6,400	$8,641.27
Total Profit %		-20%	+8%
Average Price Per Share		$10	$7.41

Table 2: Dollar Cost Averaging Example

In the example above, the investor has $8,000 to invest in shares.

Lump-Sum Investment in a Bear Market: Value $6,400

The first example is a single lump-sum payment of $8,000, which buys 800 shares at $10 per share all at once in one payment.  At the end of 8 quarters, the total share value is $6,400 – (Share Price in Quarter 8 $8 * 800 shares) – a loss of $1,600 or a brutal -20%

Dollar-Cost Averaging in a Bear Market: Value $8,641.27

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters.  As you can see, when the share price is lower, the investor gets more shares for each $1,000 invested.

When the share price is at $6, they get 166 shares for $1,000.

In this case, the share price distribution is declining across the eight quarters with a little increase at the end. The investor ultimately receives a benefit of $641.27, the difference between the share value of $8,641.27 and $8,000.

This means the dollar-cost averaging investor has a benefit of 35% over the non-dollar average investor. Not only that, but the average share price cost is also $7.41 rather than $10 per share and less than the current market price.

Despite an overall stock price decline of 20% ($10 to $8), the dollar-cost averaging strategy still managed a profit of 8%

This is the real power of Dollar-Cost Averaging. Even in a decreasing market that fluctuates 20%, she makes a profit and reduces her risk.

Dollar-Cost Averaging Strategy: Increasing Stock Price

Surprisingly in a growing market, the results are much different, with the dollar-cost-averaging investor losing out. In this example, the stock price increases from quarter one at $10 to quarter eight at $12 with the highest price of $13. Ultimately a 20% stock price increase.

		1 Payment $8,000	8 Payments $1,000
Quarter Purchased	Share Price	Number of Shares	Number of Shares
Q1	$10	800	100
Q2	$11		90.91
Q3	$11		90.91
Q4	$12		83.33
Q5	$13		76.92
Q6	$12		83.33
Q7	$13		76.92
Q8	$12		83.33
Total Shares Owned		800	685.66
Share Value Q8		$9,600	$8,227.97
Profit		20%	2.8%
Average Price Per Share		$10	$11.67

Table 2: Dollar Cost Averaging Example Bull Market

In the example above, the investor has $8,000 to invest in shares.

Lump-Sum Investing In A Bull Market

The first example is a single payment of $8,000, which buys 800 shares at $10 per share.  At the end of 8 quarters, the total share value is $9,600 – (Share Price in Quarter 8 $12 * 800 shares) – a profit of $1,600 or a 20% gain.

Dollar-Cost Averaging In A Bull Market

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters.  As you can see, when the share price is higher, the investor gets fewer shares for each $1,000 invested.

When the share price is $13, the investor gets only 76.92 shares for $1,000.

In this case, the share price distribution is increasing across the eight quarters with a slight decrease at the end. The investor received a benefit of $227.97, the difference between the share value of $8,000 and $8,227.97.

This means they have only realized a profit of 2.85%, whereas the lump-sum investor made 20%.

In an increasing bull market, moving up 20%, the investor makes a profit in both examples, but his profit is higher as a non-cost averaging investor.

Dollar-Cost Averaging vs. Lump Sum

So we have seen in these three detailed examples that there are certain advantages and disadvantages of dollar-cost averaging.

If you are lucky enough to time the market to perfection and buy-in at a low price with a lump sum and the market solidly increases over time, you will reap the maximum reward.

However, history tells us that we only have a 5% chance of this happening to us.

The reality is that the stock market fluctuates and sometimes a lot.  Even in an increasing bull market, you can make outsized returns due to the decreases in the stock price during a bull market.

Does Dollar Cost Averaging Work?

Yes, dollar-cost averaging works. When the asset price decreases and then recovers, the dollar-cost averaging strategy works out best for the investor. However, when the stock price only increases, the lump sum investor will win, assuming the investment was made at the beginning of the measured time period.

The Benefits of Dollar-Cost Averaging

• During Declining Bear Markets – Dollar Cost Averaging will ensure you are more profitable than someone making a single purchase at the top of the market.
• During Sideways Markets – you will make an abnormally high return due to you purchasing a stock at the low points in price.
• During Raging Bull Markets – you may not make the same profit as someone that obtained shares at a much lower price, but statistically, they are very lucky or extremely smart to time the market.  But think about this.  Even in a Bull Market, stocks move down in price for many weeks or months at a time, and if you are buying during these periods, your average cost per share will decrease, and your profit percentage will increase.

Dollar-Cost Averaging & Dividends

We really should not forget the golden arrow for the long-term investor, which is dividends.

If you are investing for 10 to 30 years, it is a great idea to invest in companies with a great business model, a stable market with high barriers to entry, and those that pay dividends.

Almost half of the company’s on the US, Canadian, UK, and Australian exchanges pay dividends, some up to and above 10% per annum.  Not only that, many offer Dividend Reinvestment Plans (DRIPS) and preferential prices for share purchases.  In the US also you can qualify for reduced or even Zero Tax on your dividend gains.

If you add the dividend income to the examples above, we can safely say that dollar-cost averaging over the long-term can pay off and provide a steady increase in your assets that will contribute handsomely to your investment retirement account.

Reducing the Costs of Dollar-Cost Averaging

Employing a dollar-cost averaging strategy means you will be buying a selection of stocks, again and again, every single month.  This means that your transaction costs will be a drag on the long-term compounding of your portfolio.  Luckily over the last two years, a handful of brokers have moved to a commission-free charging model.

Our favorite broker for dollar-cost averaging strategies and, in fact, everything else is Firstrade, which offers over 2,200 commission-free ETFs and free stock trading on all stocks.

Find out more about Firstrade in our review.  Learn about the best free stock trading brokers or our picks for the Top 10 US Brokers.

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