Question

Explain fully, with examples, what dollar cost averaging is. What will happen (1) if the price of an investment trends down overtime; (2) trends up; (3) trends down then up; and (4) in real life? Use excel to model and graph the result.

Answer 1

Dollar cost averaging is a technique of investment in which an investor buys a fixed dollar amount of a particular investment asset (like shares or mutual funds) on a regular basis. This investment is done without any regards to the current prevailing market price.

(1) If the price of an investment trends down overtime then the investor will end up buying more shares. Suppose that an investor invests $100 in a particular stock each month. The current price is $10 so the investor will end up with 100/10 = 10 shares. When the price drops to $5 then the inventor will have = $100/5 = 20 shares. Thus the investor’s quantity of asset held will keep on increasing as prices fall.

(2) When the prices trends up then the opposite of (1) will happen and the investor will end up buying less number of shares. Taking the example of (1) above if the prices increase to $20 per share then the number of shares bought will be = 100/20 = 5 shares. Thus the investor’s quantity of asset held will keep on decreasing as prices increase.

(3) If the prices trends down and then up then the investor will be able to average out the decrease and increase in prices as he has been buying the shares both at low prices as well as high prices.

(4) In real life when an investor uses dollar cost averaging then the investor is able to cut down his investment risks when compared to the situation in which the investor invests a lump sum amount.

An example is shown below in which an investor invests $100 per month in stock of a hypothetical company XYZ.

	A	B	A/B
Date	Amount invested ($)	Price per share ($)	No. of shares bought
1-Jan-17	100.00	6.00	16.67
1-Feb-17	100.00	7.00	14.29
1-Mar-17	100.00	8.00	12.50
1-Apr-17	100.00	9.00	11.11
1-May-17	100.00	10.00	10.00
1-Jun-17	100.00	9.00	11.11
1-Jul-17	100.00	8.00	12.50
1-Aug-17	100.00	7.00	14.29
1-Sep-17	100.00	6.00	16.67
1-Oct-17	100.00	5.00	20.00
1-Nov-17	100.00	8.00	12.50
1-Dec-17	100.00	8.50	11.76

From the above graph we can see that as price increase the number of shares purchased falls and vice versa. This enabled the investor to insulate