October 15, 2008

Example of Dollar Cost Averaging

The term Dollar Cost Averaging refers to a method of buying an investment by spending a fixed dollar amount at regular intervals. The reason for investing this way is to avoid risk in volatility in the market. If the market is going up and down over time and you were to make one large sum purchase then you might randomly hit a high or low point in the market. If you luck out you might hit the market just right and buy at a low, or you might have poor luck and buy at a temporary high value.

For a simple example, consider a stock that trades at the following prices over a few months:

January : 105
February : 110
March : 115
April : 145
May : 140
June : 125

If you bought this stock on April you'd pay the most at 145 but if you bought in January you'd pay the least at 105. If you dollar cost averaged then you'd pay an average of 123.3.

For a real world example, lets look at the past few years of the S&P 500. I get historical prices of S&P from the Yahoo finance site. (in this example I'm looking at monthly values to simplify things) Each year the index had highs and lows. If you were trying to time the market or randomly buying then you might do well if you bought at lows and you might do poor if you bought at highs. For the past 5 years the annual highs and lows of the S&P 500 were approximately:

Minimum Maximum
2008 998.01 1400.38
2007 1406.82 1549.38
2006 1270.09 1418.3
2005 1156.85 1249.48
2004 1101.72 1211.92

Graphically here are the highs and lows for each year compared to the S&P500 values per month :

If you were to invest $1000 a year and you timed things just right to hit the minimums then you'd have bought low and seen the best return. Buying $1000 of an index at the low points would give you $4,265 worth today. If on the other hand you timed things poorly and bought at the highs, then you'd have just $3,690 today. To avoid this volatility and average out the cost of your purchases you could invest $1000 / 12 or $83.33 each month. This would be an example of dollar cost averaging. If you instead bought $83.33 each month then you'd have about $3,804. This gives you an average value somewhere between the maximum and minimum.

So that gives you a Maximum of $4,265, result of Dollar Cost Averaging of $3,804 and Minimum of $3,690. As you can see the Dollar Cost Averaging method would have given you an average result.

Reference: Dollar Cost Averaging

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