Dollar Cost Average is an investing strategy that can help you lower the initial investment and maximize profits. The purpose of this strategy is to allow a smaller amount of investments at regular intervals with different price points instead of a single purchasing investment at a single price target. This investing strategy has proven to be very effective over the long term.
The Dollar Cost Averaging strategy helps to minimize the price risk exposure when you are investing in security. The whole idea is basically stating that, instead of buying an asset one time, with an initial amount at a specific price, you divide the initial amount of investment into smaller quantities to purchase at different times and prices! This aims to decrease the risk of investing in an asset at a specific price that can be too high.
For instance, let’s assume that you are willing to invest in electric vehicles and you choose XPeng (XPEV) stock for an investment of $5000. Xpeng stock is now worth $50, so you officially own $5000/$50 = 100 shares of this stock. Over the next month, the stock price has increased 6% which means +$3, and is now at $53. You decide to sell the stock and you make $3 * 100 = $300.
Now let’s see the same example if you had divided your investment into several parts. The same is true for this example, you are looking to invest in Xpeng that today is $50 but instead of $5000, you decide to put 1/5 of that, meaning a $1000.
The total number of shares 112.4 and the average price of $44.8 compared to the above example of $50.
You decide to sell the stock at the price of $53 same as above, you make $921.68 profit on your investment instead of $300.
Note: The date of purchase is a random number, this should be up to you!
The strategy works because prices tend to fluctuate every second. As we saw in the example with the use of dollar cost averaging, we divided our purchases and made multiple buys that enable us to maximize our returns and gave us the chance to achieve a lower average price. This works even better in a long-term investment.
The 401(k)-workplace retirement plan, for those who already have it, you are probably using the dollar cost averaging method by default for at least some of your investing.
This plan is effective in the United States and is a qualified retirement plan that can be sponsored by employers to their employees. It allows employees to save and invest for their own retirement on a tax-deferred basis. Employee funding comes directly off their paycheck and may be matched by the employer.
This long-term strategy tends to work because stocks are known to grow over time. But stock prices do not rise consistently over the short run, instead, they tend to fluctuate between high and low prices and that may not follow any predictable pattern. Stock prices can rise after sudden fundamental news or vice versa.
Investors tend to try to time the market and buy assets that are relatively low. However, this is not as easy as it may sound. According to Forbes, it is almost impossible to time the market even for professional analysts and stock pickers. Usually, it is not good to wait on the side until you catch a stock price that you desire because you might end up buying at a high price.
In other words, today’s low might seem high next week and this week’s high might seem low next week. Overall, trying to time the market can really cost you! This is why is good to start replacing it with this new strategy that you are learning today!
The strategy’s aim is to take the emotion out of your investment world by purchasing the same small number of shares regularly. Buying a stock when you think is a good opportunity at a small number and then investing a bigger amount when the price drops is much more efficient than trying to time the market or buying all at once.
Let’s see another example to make sure you understood the strategy.
Let’s say you have $2400 in a Mutual Fund and you have two choices:
Consider this hypothetical scenario:
Month | Share Price | No. of Shares |
January | $10 | 20 |
February | $7 | 28.57 |
March | $10.5 | 19 |
April | $11 | 18.18 |
May | $8 | 25 |
June | $9.5 | 21 |
July | $10 | 20 |
August | $11 | 18.18 |
September | $8 | 25 |
October | $7 | 28.57 |
November | $9.5 | 21 |
December | $12 | 16.67 |
The average price is $9.45 and the shares you would own are 261.17.
But if you invested all your money in January you would have 240 shares at a price of $10.
From year it is in your discretion to use any type of strategy you want.
For those who are looking to invest long term into a company dollar cost averaging can be a great strategy to help you boost returns. On the other hand, this strategy might not fit you if you are a short-term investor with more knowledge of the financial markets. I am glad I contributed to your future potential profits! Make sure you go back to our stock encyclopedia and learn another term before the end of the day!
