Dollar cost averaging does not assure a profit and does not protect
against losses in a declining market.
Dollar cost averaging requires an investor to make continuous
investments regardless of the fluctuating price levels.
Investors should therefore consider their financial ability to
continue purchases through periods of low levels.
Assume
you are making monthly contributions of $200.
You purchase XYZ for $20 per share.
With a $200 investment, you purchase 10 shares.
The following month, shares of XYZ drop precipitously to $10. At $10 per share, you purchase 20 shares.
What
price would XYZ shares have to reach for you to break even--$10.00,
$15.00, or $20.00?
Your
total investment is $400 ($200 X 2).
The number of shares you own is 30 (20+10).
Your cost basis per share is $13.33 ($400/30 shares).
Even though you bought shares at $20 and then at $10, the
price of XYZ investment only needs to reach $13.33 for you to break
even, not $15.00. This
is the result of dollar cost averaging.
With the same $200, you are able to purchase twice as many
shares at $10 than at $20.
If the
shares of XYZ were to drop to $5.00 per share the following month,
you would be able to purchase 40 shares.
Your new cost basis would drop from $13.33 to $8.57.
Even though the value of the security dropped to $5.00 per
share, it would only have to reach $8.57 to break even.
However,
if you had invested $600 all at once when XYZ was at $20, you would
have purchased 30 shares. If
XYZ dropped to $5.00 per share, your initial investment would be
worth $150. This is a
loss of $450.00 ($600.00-$150.00). You would have to wait for the shares to reach $20 to break
even.
In
a rising market, the opposite occurs.
As the share price of a security increases, you buy fewer
shares. Assume you are
making the same monthly contributions of $200.
You purchase XYZ at $20 per share.
With a $200 investment, you purchase 10 shares.
The following month shares of XYZ rise precipitously to $40.
At $40 per share, you are able to purchase 5 shares.
If XYZ were to fall back to $20, your cost basis would be
$26.66 ($400.00/15 shares), not $30/share.
Of course if the market continues to rise and never falls,
your opportunity cost would be the profits lost if you had invested
all your money initially.