Investors have three major concerns when buying stocks: making a profit on their investment, minimizing risk, and the actual rate of return they will receive (including any dividend income). Ideally, there would be windfall profits in record time with no risk. In the real world, investors must use stock strategies that match both their resources and skill level. The dollar cost averaging stock strategy is a great approach for people new to stock investing that minimizes risk and trends towards sound profitability -- especially the longer it is used.
Basics of Dollar Cost Averaging
The dollar cost averaging stock strategy minimizes risk because it reduces the difference between the initial investment and the current market value over a long enough timeline. This is accomplished by making fixed investment amounts at predetermined times. Now this investment could be in a specific stock or perhaps even an index fund.
The point is to remain committed to this investment for years and not to allow fluctuations in price to affect your buying strategy.
Knee jerk responses are common with stock investments, especially for beginners. One bad earnings report can send stock prices tumbling and cause investors to panic. This causes a sell-off that further lowers prices. But; if a person were to keep their stock and still continue buying at regular intervals, the average price of the stock should continually approach the current market value at the time of purchase at each interval. Temporary fluctuations in pricing should even out. While the stock price may be lower than the initial investment value, the ability to acquire more shares at a lower price means that the short-term decrease in average stock price should be balanced out when the share price increases. However, never confuse dollar price averaging with simple averaging.
For instance, let's say an investor purchased 1,000 shares of Microsoft stock at $40 per share at the first interval and another 1,000 shares of stock at the next for $25 a share. That would make the total investment $65,000 and the average stock price $32.50. However, this is not dollar cost averaging -- it is simple averaging.
The average cost of the stock will not trend towards the current market value if you do not remain consistent in your investment strategy. Using dollar cost averaging, a person would invest a fixed amount -- say $33,000 per interval. Thus, when buying the same Microsoft stock at the first interval, a person would end up with 825 shares of stock at $40/share and 1,320 shares at $25 each. This adds up to 2,145 shares and an average cost of $30.75 -- closer to the current market value of $25 than the simple averaging strategy.
From the example above, the one drawback to the dollar cost averaging strategy is revealed: while it reduces risk and lowers the difference between the average stock price and the current market value, it will not eliminate the possibility of a loss if the average price does not move fast enough. In fact, if an investor were to pick a stock that was on its way down and continued investing in regular intervals as advised by the dollar cost averaging strategy, the losses could add up rapidly.
While the investor may be buying more shares at each interval due to lower prices, having more shares of continually declining stock simply adds insult to injury. For this reason, an investor must have a cutoff point at which he/she ceases purchasing the stock at regular intervals. Fluctuations in market price can be absorbed and an investor can still make a healthy profit using the dollar cost averaging stock strategy but a declining stock is just a loser. Unfortunately, the dollar cost averaging strategy is most profitable on stocks that were underperforming at the time the investment plan was initiated. Therefore, the best stocks to make the most profits on are also the ones
that are more likely to recover and continue trending upwards in share price. Prudent research is necessary before initiating any dollar averaging stock strategy.
Implementing a Dollar Cost Averaging Strategy
The very first step in planning to use this strategy is determining how much you can realistically afford to invest over an extended period of time. This is very important because the strategy will not reduce risk of loss effectively unless the investment amount is consistent. You will not insulate yourself against losses as effectively when a large initial investment is made and then followed by increasingly smaller amounts. In such a scenario, the gap between the average stock price and current market value will be larger and the risk for loss greater.
The next step in this or any other stock strategy should be to choose your investment carefully. Remember, you need to stay with this investment for many years for the strategy to be effective. An investor will get killed if they purchase an underperforming stock that does not recover. For this reason, combining the benefits of dollar cost
averaging strategy with the diversification and reduced risk of an index fund is a prudent approach when choosing an investment.
An index fund is like a mutual fund in that it is designed to mimic the returns of prominent benchmarks such as the Dow Jones Industrial Average or the S&P 500. Investors own a fraction of each stock that makes up the index. The principle difference and benefit to investors in an index fund is that their management fees are a fraction
of those charged for actively managed mutual funds. This is because index funds are passively managed. By combining the dollar cost averaging strategy with the increased diversification and reduced management/transaction fees of an index fund, an investor can maximize the profit potential and minimize risk.
Finally, pick an interval that you can be consistent with for years into the future. A weekly interval will work but it is probably best to make it monthly or even quarterly. Longer intervals are better because they reduce the expense of multiple transaction fees and also allow you to buy larger numbers of stock with each purchase.