Dollar cost averaging (DCA) is a technique designed to reduce risk when purchasing stocks or mutual funds. If you have a 401k with your employer you’re already dollar cost averaging every time they purchase stock for you.

The idea behind dollar cost averaging is to repeatedly invest a set amount of money regardless if your investment goes up or down. If your investment decreases in value, you will be buying more shares at a cheaper price; if it goes up you’ll be making money on your existing investment. This is only recommended for long-term investors, so buying solid mutual funds (index funds are recommended) or large-cap stocks is suggested. Let’s take a look at an example:

In January 2006 you decide that you want to get into the “market”, and decide to invest in Vanguard’s S&P 500 Index Fund (VFINX). You have $10,000 saved and you want to invest it all. You have two choices:

1. Go to the Vanguard website, print the forms, and mail them a check for $10,000.
2. Go to the Vanguard website, print the forms, and mail them a check for $3,000 (their minimum for new accounts), and dollar cost average the other $7,000 at $1,000 a month for 7 months.

Let’s take a look at option #2:

• 2/1/06: Your check for $3,000 gets cashed, and you buy 25.38 shares of VFINX at $118.19 a share. With mutual funds you don’t have to buy shares in whole units, you can buy fractional shares (that’s the .19 part)
• 3/1/06: You’ve set up an automatic investment plan with Vanguard, so they pull $1,000 from your checking account and you buy another 8.38 shares at $119.27. The fund has gone up (from $118.19 to $119.27), so your initial investment made money, but you paid more for this month’s shares.
• 4/3/06: The fund goes up again, to $119.52. Your $1,000 now buys you only 8.36 shares. Fewer shares than last month, but you’re making money on your past investments.
• 5/1/06: You’re a stock market genius! Your mutual fund is up to $120.33 a share. However, your $1,000 is now only buying 8.31 shares.
• 6/1/06: What’s going on? Your fund dropped to $118.78! You just lost money! Actually, you didn’t lose anything, unless you sold it. Markets go up and down. That’s why averaging works. Your $1,000 now buys 8.41 shares
• 7/3/06: Again, your fund drops. This time to $117.93! You’re asking yourself, “What did I do to deserve this?” Your $1,000 buys you 8.47 shares. You are able to acquire more shares, as the price drops.
• 8/1/06: Now I’m getting worried! The fund drops again. This time to $117.17 a share! The good news is that your $1,000 is now buying 8.53 shares vs 8.47 last month.
• 9/1/06: You’re a stock market genius again! The fund jumps to $121.15 a share! You’re making some serious money on your past contributions to the fund, but your $1,000 only buys 8.25 shares.

Your investment increased in value when it went up, and you were able to buy more shares when it went down. Dollar cost averaging allowed you to buy at an “average” cost over time. After you finish investing your $10,000, you may want to add $100 a month to the fund to increase your position. Again, dollar cost averaging your investment.

Even though dollar cost averaging reduces risk, there is still some risk involved. As you can see from the chart below, if you started the above scenario in February 2000, and continued with your $100 monthly investments, you would have been buying shares in a fund that consistently dropped in price for about 30 months. The shares you would have purchased on 2/1/2000 would not have broken even until December 2007. However, all those shares you bought on the way down would have recovered earlier. For example, shares purchased in January 2002 would have started to turn profitable in early 2004 and then again in early 2005. Overall, your “average” cost would be lower than making one purchase in February 2000, so your overall portfolio value would be higher.

Dollar Value Averaging

Though there are lots of supporters of Dollar Cost Averaging, there are also many critics. Some critics have come up with an alternative called: Dollar Value Averaging (DVA).

In DCA you invest the same amount through a series of recurring purchases, regardless of the price. With DVA you set a dollar target for your portfolio balance to increase regardless of market fluctuations.

Using the previous example, let’s say you want the value of your VFINX mutual fund to increase by $1,000 every month:

• 2/1/06: Your check for $3,000 gets cashed, and you buy 25.38 shares of VFINX at $118.19 a share, as before. Your fund starts out at $3,000.
• 3/1/06: The target value for your fund this month is $4,000 (a $1,000 increase from last month). The fund price increased from $118.19 to $119.27. So your balance is now worth $3,027 (25.38 shares x $119.27). You’ve made $27. Since you want the value to increase by $1,000 each month you only need to invest $973 ($1,000-$27). You’ve just added 8.15 shares ($973/$119.27), for a total of 33.53 shares.
• 4/1/06: This month’s target value is $5,000. Let’s assume the fund drops to $118.50 this month. The value of your fund is now $3,973. You need to invest $1,027 to keep the value of your fund at the target $5,000.

Value averaging is more work than dollar-cost averaging. “It makes you do some math every month,” says John Markese, president of the American Association of Individual Investors. The advantage to dollar cost averaging is that you can set up an automatic payment plan from your checking account and forget about it.

Dollar Cost Averaging with Stocks

Most mutual funds were designed for dollar cost averaging. They make it easy for you and don’t charge a transaction fee for each purchase.

If you try dollar cost averaging stocks by buying them the traditional way, through brokers, you’ll be losing money before you start. If you invest $100 in a stock, and pay your broker $9.95 in commission, the stock needs to rise 10% before you break even!

Sharebuilder.com resolved this by offering two low-cost investment plans:

1. $12 per month for 6 automatic investments per month ($2.00 per investment)
2. $20 per month for 20 automatic investments per month ($1.00 per investment)

These plans work well if you want to invest $100 or more per month, per investment. For option A, a $2 charge for $100 a month would be a 2% transaction fee. For option B, it would be 1%. An investment in option A lower than $100 would increase your transaction fee to higher than 2% and not be worth the hassle. Most solid mutual funds have expenses set at 1.25% or lower. One of the lowest fees around, the Vanguard S&P index fund we used as an example above, is set at .18%.To make this work you would need to invest at least $100 a month per investment; in option A that’s $600 a month (6 stocks), in option B $2,000 (20 stocks) a month.

Another option is buying stocks direct, without a broker. Yes, you can buy stocks like Bank of America (BAC), ExxonMobil (XOM), and Pfizer (PFE) direct from the company with no fees.  For more detailed information read our article; Buying Stocks Without A Broker; The Sane Way.