Understanding dollar cost averaging

One powerful tool that we have as investors is the technique known as dollar cost averaging, the process of investing in periodic contributions over time rather than all at once. By doing so, we can guard against the frustration of buying a stock at its peak only to see the price come crashing down. And there’s also a benefit that may not be obvious at first. Let me explain:

Let’s say we have $3,000 to invest in a mutual fund. But instead of investing it all at once, we’re going to spread our purchases out into three equal $1,000 buys over three months. The first month, the price per share is $50. In the second month, the price has increased to $150. And in the third month, the price has fallen to $100. You might think that your average cost per share would be $100, since that’s the average of the three purchase prices. But a quick check of the math shows that our actual cost per share is $81.82.

$1,000 per purchase

$50 share price = 20 shares

$150 share price = 6.67 shares

$100 share price = 10 shares

Total spent is $3,000 on 36.67 shares, for an average cost per share of $81.82.

Why does this work? Because we bought more shares at the lower price and fewer shares at the higher price. This is one of the reasons why making regular investments, such as payroll deductions for a 401(k) plan, can be such an effective tool for building wealth.

DISCLAIMER: Wendell the Pug is a noncertified financial planner who does not possess a 401(k) and, in fact, has never actually held down a paying job.