What should you do with the funds you keep at your favorite discount broker? Should you invest all your money in a lump sum or dollar cost average into the market? Before we make those decisions, let’s define what dollar cost averaging is first.
I give up. As I’ve already mentioned, I’ve been following this one stock and it’s driving me batty. Ever since I sold my moderately attractive position in it, it’s soared. So what to do? I still want to build my stake in it and ride its cycle. Its cycle is expected to be two or three years long. We’re at the trough right now, or at least, that’s where I think we’re in. And because it hurts too much to not be part of this stock’s ride, I decided to resort to my tried, true and tested strategy for entering the market and building a stock position. I don’t know why I refused to do it before — perhaps, I was betting on a short term collapse prior to its expected run up. But in the absence of such a gift horse buying opportunity, I am simply going to have to dollar cost average.
Dollar cost averaging is the practice of buying into the market (or into a specific equity) at systematic intervals. You buy a bit now, a bit later, a bit when the cows come home. You buy in installments, ignoring the bucking market. By doing so, you can smooth out the volatility in your stock purchase price and earn not only a more acceptable average price for your stock position, but also some peace of mind and more restful sleep. And you can cut down on your anti-anxiety/stress medication at the same time!
Here’s how you can do it.
- Identify your target stock or mutual fund. Where do you want to put your heard earned $$$? Hint: oats, pork bellies, or ethanol may not be your best bets.
- Determine how much you want to invest in this stock or fund.
- Decide how long a time period you would like to take to build a position. In my case 1 month to 6 months will work for me.
- Divide the amount you are going to invest by the time period you decided to spend investing. That magic number is how much you will be putting into the market at any one time, on a regular schedule. That will be your trade amount or mutual fund investment amount.
- If you are investing in mutual funds, by setting up an automatic investment program, you are already participating in dollar cost averaging.
- After all those steps, you can now return to your usual activities and ignore how the market bounces. Well, most of the time. You will still need to keep a fairly close eye on your investments but at least you can assure yourself you are keeping Murphy’s Law at bay.
Here is an example of how it works:
| Invest date | Amount | Price per share | Shares purchased |
| Jan 2004 | $1,000 | $100 | 10 |
| Apr 2004 | $1,000 | $70 | 14.28 |
| Jul 2004 | $1,000 | $90 | 11.11 |
| Oct 2004 | $1,000 | $80 | 12.50 |
| Jan 2005 | $1,000 | $70 | 14.28 |
| Apr 2005 | $1,000 | $50 | 20 |
| Oct 2005 | $1,000 | $80 | 12.50 |
| Nov 2005 | $1,000 | $90 | 11.11 |
| Dec 2005 | $1,000 | $100 | 10 |
| Mar 2006 | $1,000 | $90 | 11.11 |
| Total | $10,000 | $78.81 avg. | 126.89 shares owned |
For those of you with an automatic debit from your paycheck going into your 401K plan, then you are employing this strategy in its classic form. For my more discretionary investments, I tweak the strategy a little. For example, in this single stock scenario, I will decrease my trade amount when the price is higher. When the price goes down, I may double up. I may not buy on a totally regular schedule but wait for certain trigger points to buy — my point is that I am trying to manage how I feel about my position; when the stock goes up or down and I am not bothered, then I know I’m in a happy place.
Of course, investing is always something you need to keep tabs on but for those with a long time horizon, dollar cost averaging is quite a good strategy. It’s the only time I feel like jumping up and down with glee when the market crashes or my stock of choice plummets.
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Good explanation on how it works… Be sure to check out my thoughts on DCAing (also included in this week’s Carnival of Investing): The Downside of Dollar Cost Averaging
I do the dollar-cost-averaging thing in my 401K because I can’t really manage that money easily (just have mutual funds). But, depending on how one weights their portfolio, there are other options… I like trading in the range, and have struggled with the dollar-cost-averaging thing in my trading account. I did a post talking about an alternative here…
http://www.thealexblog.com/2006/11/05/rule-1-trade-with-the-wind-at-your-back-don%e2%80%99t-average-down/
Emotions are probably one of the hardest things to overcome in investing - nice post. Learn to treat investing like a business and try not to get too personal. Dollar cost averaging is a great way to do that.
Dollar cost averaging is great. There are so many good things about retirement accounts that are ever better than the benefit of it but you don’t have to choose. You get tax deferred growth, long term savings plan, compounding… and dollar cost averaging.
Seems like a good way to minimize risk. You’re going to lose some of your upside potential as well, but it definitely guards you against devastating losses.
If you treat trading and investing as a job, lossess become less emotional for you. Dollar cost averaging is probably one of the wiser strategies when it comes to managing your investment portfolio.