Dollar-Cost Averaging: How It Works To Maximize Ptofits

Dollar-cost averaging is an investment strategy that divides the total investment amount across periodic purchases, reducing risks from lump-sum investments and capitalizing on market price variations.

What Is Dollar Cost Averaging?

Dollar-cost averaging (DCA) is a commonly used investing strategy. If you regularly contribute to a retirement fund or your investment portfolio, you automatically use dollar cost averaging. This regular contribution averages out the overall cost of the investment.

If the stock price decreases over time, the investor will receive more shares for their money, meaning the asset’s average price decreases. This decreases the cost per share, promoting a successful investing outcome. If the stock price increases, they get fewer stocks, increasing the average cost.

Dollar Cost Averaging Formula

The formula for calculating the dollar cost average over three purchase periods looks like this.

Dollar Cost Average = ((P * T) + (P * T) + (P * T)) ÷  ∑ T

Where:

• P = Stock Price
• T = Number of Shares Purchased.

An even simpler formula for calculating the Dollar Cost Average.

Dollar Cost Average = Total $ Amount Invested ÷ Total Number of Shares Owned.

Dollar Cost Averaging During a Bear Market

In stock market terms, stock prices go up and down. Dollar-cost averaging takes advantage of the down period to buy more stock, and as the stock price rises, less stock is purchased for the same amount.

But here is the clever thing.

If you apply the concept of Dollar Cost Averaging to your investments during a bear market, you can reduce your overall average cost per share.

Example: Dollar Cost Averaging vs. Lump Sum

In this example, we compare investing over eight time periods versus investing a simple lump sum of money. If the stock’s cost fluctuates downwards but then returns to the same or higher price, you have benefitted from dollar cost averaging.

The stock price fluctuates around the $10 mark in the table below, spending equal time above the $10 price below it.

In the example above, the investor has $8,000 to invest in stocks.

Lump-Sum Investment

The first example is a payment of $8,000, which buys 800 shares at $10 per share. At the end of 8 quarters, the total share value is $10,400 – (Share Price in Quarter 8 * 800 shares)

The Dollar Cost Averaging Investment

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters. As you can see, the investor gets more shares for each $1,000 invested when the share price is lower.

When the share price is $7, the investor receives 142 shares for $1,000. Also, when the share price is higher at $13, the investor receives only 76.92 shares.

Here, we assume the share price distribution is equal across the eight quarters. The dollar cost average investor has, in the end, received a benefit of $391 (the difference between the share value of $10,400 in example 1 and $10,791 in example 2).

This means the dollar cost-averaging investor makes a profit of 35%, and the lump-sum investor makes a gain of 30%. The average share price cost is also $9.64 rather than $10 per share.

So, all things being equal, especially the share price and dollar cost average come out on top with an improved profit of 3.8%.

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Example: Dollar Cost Averaging Strategy – Declining Stock Price

In this example, we examine the effects of dollar cost averaging if the asset’s price continues to decline throughout the investment. The stock price reduces from quarter one at $10 to quarter eight at $8, with the lowest price of $6.

In the example above, the investor has $8,000 to invest in shares.

Lump-Sum Investment in a Bear Market

The first example is a single lump-sum payment of $8,000, which buys 800 shares at $10 per share in one payment. At the end of 8 quarters, the total share value is $6,400 – (Share Price in Quarter 8 $8 * 800 shares) – a loss of $1,600 or a brutal -20%

Dollar Cost Averaging in a Bear Market

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters. As you can see, the investor gets more shares for each $1,000 invested when the share price is lower.

When the share price is at $6, they get 166 shares for $1,000.

In this case, the share price distribution is declining across the eight quarters with a little increase at the end. The investor ultimately receives a benefit of $641.27, the difference between the share value of $8,641.27 and $8,000.

This means the dollar cost averaging investor benefits 35% over the non-dollar average investor. Not only that, but the average share price cost is also $7.41 rather than $10 per share and less than the current market price.

Despite an overall stock price decline of 20% ($10 to $8), the dollar cost averaging strategy still managed a profit of 8%

This is the real power of Dollar Cost Averaging. Even in a decreasing market that fluctuates 20%, she makes a profit and reduces her risk.

Dollar Cost Averaging Strategy: Increasing Stock Price

Surprisingly, the results are much different in a growing market, with the dollar cost-averaging investor losing out. In this example, the stock price increases from quarter one at $10 to quarter eight at $12, with the highest price of $13. Ultimately, a 20% stock price increase.

In the example above, the investor has $8,000 to invest in shares.

Lump-Sum Investing In A Bull Market

The first example is a payment of $8,000, which buys 800 shares at $10 per share. At the end of 8 quarters, the total share value is $9,600 – (Share Price in Quarter 8 $12 * 800 shares) – a profit of $1,600 or a 20% gain.

Dollar Cost Averaging In A Bull Market

In this example, the investor spreads the payment of $1,000 in 8 installments over eight quarters. As you can see, the investor gets fewer shares for each $1,000 invested when the share price is higher.

When the share price is $13, the investor gets only 76.92 shares for $1,000.

In this case, the share price distribution increases across the eight quarters, with a slight decrease in the end. The investor received a benefit of $227.97, the difference between the share value of $8,000 and $8,227.97.

This means they have only realized a profit of 2.85%, whereas the lump-sum investor made 20%.

In an increasing bull market, moving up 20%, the investor makes a profit in both examples, but his profit is higher as a non-cost averaging investor.

Dollar Cost Averaging vs. Lump Sum

In these three detailed examples, we have seen certain advantages and disadvantages of dollar cost averaging.

If you are lucky enough to time the market to perfection and buy in at a low price with a lump sum, and the market solidly increases over time, you will reap the maximum reward.

However, history tells us that we only have a 5% chance of this happening.

The reality is that the stock market fluctuates sometimes a lot. Even in an increasing bull market, you can make outsized returns due to the decreases in the stock price during a bull market.

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Does Dollar Cost Averaging Work?

Yes, dollar cost averaging works. When the asset price decreases and recovers, the dollar cost averaging strategy works best for the investor. However, when the stock price only increases, the lump sum investor will win, assuming the investment was made at the beginning of the measured period.

The Benefits of Dollar Cost Averaging

The main benefit of dollar cost averaging is that it reduces the risk of investing in volatile markets. By investing at regular intervals, you’re essentially smoothing out your return over time. This makes it easier to stomach any losses in the short term as you know more money is coming in from the next investment. Additionally, since investments are made on a regular basis rather than all at once, you’re not stuck with a large sum of money invested in markets during a downturn. This also helps protect against the emotional mistakes investors make when they try to time the market.

Another benefit of dollar cost averaging is that it creates a regular investment habit for investors. It’s easier to stay disciplined and consistently invest if you know you’ll automatically be investing every month.

During Declining Bear Markets.

Dollar Cost Averaging will ensure you are more profitable than someone making a single purchase at the top of the market. It works to your advantage because you can take advantage of the dips in share price as they average out over time rather than being stuck with a single purchase.

This strategy can also help reduce the emotional pain associated with investing. By spreading investments out over time, investors don’t have to worry about short-term drops in the market and can remain focused on their long-term goals.

During Consolidating Markets.

You will make an abnormally high return due to purchasing a stock at a low point in price. Your overall cost per stock will be much lower than the average purchase price of the shares. This is great for investors who are looking to maximize their return on investment.

During Bull Markets.

You may not make the same profit as someone who obtained shares at a much lower price, but statistically, they are very lucky or extremely smart to time the market. But think about this. Even in a Bull Market, stocks move down in price for many weeks or months at a time, and if you are buying during these periods, your average cost per share will decrease, and your profit percentage will increase.

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Dollar Cost Averaging & Dividends

We should not forget the golden arrow for the long-term investor: dividends.

If you are investing for 10 to 30 years, investing in companies with a great business model, a stable market with high barriers to entry, and those that pay dividends is a great idea.

Almost half of the companies on the US, Canadian, UK, and Australian exchanges pay dividends, some up to and above 10% per annum. Also, many offer Dividend Reinvestment Plans (DRIPS) and preferential prices for share purchases. You might qualify for reduced or even zero tax on your dividend gains in the US.

Suppose you add the dividend income to the examples above. In that case, we can safely say that dollar cost averaging over the long term can pay off and provide a steady increase in your assets that will contribute handsomely to your investment retirement account.

Reducing the Costs of Dollar Cost Averaging

Employing a dollar cost averaging strategy means buying a selection of stocks repeatedly every month. This means that your transaction costs will drag on your portfolio’s long-term compounding.

Luckily, a handful of brokers have moved to a commission-free charging model over the last two years.

Our favorite broker for dollar cost averaging strategies and everything else is Firstrade, which offers over 2,200 commission-free ETFs and free stock trading on all stocks.

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