The Dollar Cost Averaging Theorem is a strategy that involves investing a fixed amount of money in a security at regular intervals, regardless of the price fluctuations. The idea is to reduce the average cost per share and the impact of market volatility by buying more shares when the price is low and fewer shares when the price is high. This way, the investor does not need to worry about timing the market or making a lump sum investment at a potentially unfavorable price.
For example, suppose an investor decides to invest $100 every month in a mutual fund for a year. The table below shows how many shares they would buy each month, depending on the fund’s price, and what their average cost per share would be at the end of the year.
Table
| Month | Fund Price | Shares Purchased | Total Shares | Total Cost | Average Cost |
|---|---|---|---|---|---|
| 1 | $10 | 10 | 10 | $100 | $10 |
| 2 | $8 | 12.5 | 22.5 | $200 | $8.89 |
| 3 | $12 | 8.33 | 30.83 | $300 | $9.73 |
| 4 | $15 | 6.67 | 37.5 | $400 | $10.67 |
| 5 | $9 | 11.11 | 48.61 | $500 | $10.29 |
| 6 | $11 | 9.09 | 57.7 | $600 | $10.39 |
| 7 | $13 | 7.69 | 65.39 | $700 | $10.70 |
| 8 | $7 | 14.29 | 79.68 | $800 | $10.04 |
| 9 | $10 | 10 | 89.68 | $900 | $10.04 |
| 10 | $14 | 7.14 | 96.82 | $1000 | $10.33 |
| 11 | $16 | 6.25 | 103.07 | $1100 | $10.67 |
| 12 | $12 | 8.33 | 111.4 | $1200 | $10.77 |
As you can see, the investor’s average cost per share is $10.77, which is lower than the average fund price of $11.17 over the year. The investor also ends up with 111.4 shares, which is more than they would have if they had invested $1200 at once at any of the monthly prices.
The Dollar Cost Averaging Theorem can be a useful way to invest in volatile markets, as it reduces the risk of buying at the wrong time and helps the investor benefit from price fluctuations. However, it also has some drawbacks, such as missing out on potential gains if the market trends upward, paying more transaction fees and taxes, and requiring discipline and patience to stick to the plan. Therefore, investors should weigh the pros and cons of this strategy and compare it with other alternatives, such as lump sum investing or value averaging.
Procedures for Implementing Dollar Cost Averaging in Excel
- Set Up Your Excel Spreadsheet: Create a new Excel spreadsheet and label columns for Date, Investment Amount, Share Price, Shares Bought, and Total Investment.
- Input Historical Share Prices: Enter historical share prices for the investment you are considering. You can obtain this data from financial websites or databases.
- Determine Investment Frequency: Decide how often you will invest. Common frequencies include weekly, bi-weekly, or monthly.
- Calculate Shares Bought: Use the formula
Shares Bought = Investment Amount / Share Priceto determine how many shares you will buy with each investment. - Track Total Investment: Update the Total Investment column by adding the current investment amount to the previous total.
- Repeat: Continue these steps for each investment period.
Comprehensive Explanation with a Scenario
Let’s consider a scenario:
- Investment Amount: $1,000 per month
- Initial Share Price: $50
- Historical Share Prices (Month 1 to Month 6): $50, $45, $55, $40, $60, $50
| Date | Investment Amount | Share Price | Shares Bought | Total Investment |
|---|---|---|---|---|
| Month 1 | $1,000 | $50 | 20.00 | $1,000 |
| Month 2 | $1,000 | $45 | 22.22 | $2,000 |
| Month 3 | $1,000 | $55 | 18.18 | $3,000 |
| Month 4 | $1,000 | $40 | 25.00 | $4,000 |
| Month 5 | $1,000 | $60 | 16.67 | $5,000 |
| Month 6 | $1,000 | $50 | 20.00 | $6,000 |
Calculation and Result
- Total Shares Bought: 122.07
- Average Share Price: $49.12 ($6,000 / 122.07)
Over the six-month period, the average share price is lower than the highest and higher than the lowest, showcasing the benefit of Dollar Cost Averaging.
Other Approaches
- Moving Average Strategy: Calculate the moving average of share prices over a specific period. Invest when the current price is below the moving average.
- Percentage of Portfolio Strategy: Allocate a fixed percentage of your portfolio to a particular investment, adjusting based on market conditions.
- Rebalancing Strategy: Regularly rebalance your portfolio by selling assets that have appreciated and buying those that have underperformed.
