What is Dollar Cost Averaging?

Dollar Cost Averaging is one of tried and tested ways to reducing risk in your portfolio. Basically, you keep on buying the stock at regular intervals. A good strategy is to apply this to stocks going down. Since every time the stock goes down you buy it at a cheaper price, you can make up for the loss or even make a profit on the stock without the stock going all the way back up to where you initially started buying it.

Lets see this in action in an example. For RegularInvestment(RI) and DollarCostAveragingInvestment(DCAI) start out with 20 units of stock at $50 or $1000(50*20) initial investment. With DollarCostAveragingInvestment you buy 10 unit of stock every time the stock price fluctuates by $10.

Timeline StockPrice RegularInv. RI Profit DollarCostAvgInv. StockPurchase DCAI Profit
1 $50(stock falling) $1000 (50*20) 0 $1000 ($50*20 units) $1000 0
2 $40 $800 (40*20) ($200) $1200 ($40*30 units) $400(10*40) ($200)
3 $30 $600 (30*20) ($400) $1200 ($30*40 units) $300(10*30) ($500)
4 $20(stock rising) $400 (20*20) ($600) $1000 ($20*50 units) $200(10*20) ($900)
5 $30 $600 (30*20) ($400) $1800 ($30*60 units) $300(10*30) ($400)
6 $40 $800 (40*20) ($200) $2800 ($40*70 units) $400(10*40) $200
7 $50(Back to Initial Price) $1000 (50*20) 0 $4000 ($50*80 units) $500(10*50) $900

Hence, your regular investment yielded no net profit while the stock went from $50 down to $20 and again backup to $50.

However, using dollar cost averaging you actually end up with a gain of $900 on your total investment of $3100 (1000+400+300+200+300+400+500)

Profit = Total investment value - Total Stock Purchases = $4000 - $3100 = $900.

Applying Dollar Cost Averaging in a Bad Economy/Recession
This can be a useful strategy during downturns when you can recuperate your initial investment even without the stock going completely back up to its initial price. However, keep in mind there is no guarantee that the stock will fully recover back. Hence, this strategy should only be used on stocks or ETFs that you think can recover the downturn.

A good strategy is to apply this to secular growth stocks(as opposed to cyclical stocks). Secular growth stocks have good long term growth prospects and are not heavily dependant on market cycles like cyclical stocks. Examples of secular stocks include health nutrition stocks and discount stores whereas an example of a cyclical stock would be an average growth technology stock.

Alternatively, you can also identify long-term high growth segments of an industry and pick good quality, solid stocks in those segments to dollar cost average on. On a market turnaround, you can always invest in some technology stocks for a bit of leverage.

Applying Dollar Cost Averaging to Buying/Selling Stocks
Have you ever heard of an investor that put a huge chunk of money in a stock and then to his demise, right after buying the stock, the stock took a huge hit and the investor lost a major chunk of his investment? What about an investor that sold a huge chunk of his investment in an existing stock, and then right after selling the stock, the stock skyrocketted?

In order to avoid such scenarios, it is often wise to buy or sell stocks in increments. Say for instance, if your stock has advanced quite a bit and you want to sell it, sell some portion of it and then wait for some time and then sell more- in that sequence. Same is true while buying stocks. In that way, you won't buy or sell stocks at the worst time.

However, in some cases, it might still be okay to buy or sell stocks in just one lot. Say for instance, a stock took a huge hit and its been down for quite sometimes and you feel that it has bottomed out. You feel confident and buy the stock in one trade. Likewise, if the stock has taken a huge leap, and you think that it has gone too high and might not advance any further, then it might be ok to sell your whole position.

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