by Peter K

Created on: January 04, 2008

In simple terms, dollar cost averaging means you purchase approximately the same amount (in dollars) of a security multiple times at regular intervals. As the transactions take place with different share prices at each purchase interval, the per-share cost is averaged over multiple transactions. This method of purchasing securities largely eliminates price risk, the potential for a security to be overvalued at any one time, and instead averages your cost of the security to reflect a price closer to the stock's true long-term value.

In practice, dollar cost averaging in simple to understand. Let's say you purchase 10 shares of Security X at $100 per share on January 1st for a total transaction price of $1,000. On February 1st, you decide to invest another $1,000, but the share price has decreased to $50, resulting in a buy transaction for 20 shares. Your account now has 30 shares of Security X purchased for a total of $2,000, or an average price of $66 per share. On March 1st, you purchase another 40 shares at $25 per share (the stock just keeps on falling!), and the total is once again $1,000. Now, your account has 80 shares at a total cost of $3,000. That's $37.50 per share. Compare that to if you had invested all $3,000 on January 1st. You would now have lost a substantial portion of your investment. Instead, the stock price need only rise from $25.00 to $37.50 in order for you to break even a much more likely outcome than a rally back to $100!

Dollar cost averaging is typically used by long term investors wishing to minimize the effect of price fluctuations on their purchase orders. It can also be used in the same manner to buy mutual funds and other securities.

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