Dollar Cost Averaging - Calculating the Average Share Price
Dollar Cost averaging is an investment mechanism in which stocks are purchased at constant dollar amounts at regularly spaced intervals, with the most amount of stocks bought at the lowest stock prices possible. By investing a fixed amount of money each time, more shares are bought at lower prices and fewer shares are bought at higher prices. This approach results in a lower average cost per share because the investors buy more shares of the same stock at the lower prices. The formula for dollar cost averaging is:
An investor invests $200,000 per month in IBM shares and performs the following transactions:
What would the average cost per share be?
With this $1.6 million investment, a total of 12,590 shares have been bought at an average cost of $127.13 per share.
If the investors can manage to sell their shares at a price above $140, they will easily make a gain of $140 / $127.13 = 1.10%.This is the whole purpose of dollar cost averaging, to reduce the total average cost per share.
Dollar Cost Averaging is advantageous to investors when a stock price moves within a narrow range such that if there is a decrease in stock price, the investor will incur less of a loss with this approach. If there is an increase in the stock price, the investor will gain more. The advantages of dollar cost averaging are:
Dollar cost averaging is known to be a conservative investment strategy because it avoids the investors from buying when the market is too high or sell when the market is too low. Investors buying stocks on dollar cost averaging approach buy with a long term view to stock appreciation which could benefit them immensely. Also with this approach, the investor minimizes risk because he is not stuck with too many shares bought at high prices. Another advantage is that during a bear market, more shares can be bought at even lower prices. The graph below shows the share price for each investment made from Jan to Aug 2010 and the total # of shares purchased.