Dollar Cost Averaging

You're dead sure that shares of Unbeatable Software Ltd at Rs 50 are a great investment. Your broker agrees and so you buy a 1,000 shares for Rs 50,000. A week later, the stock's down to Rs 40 and you are carrying a potential loss of Rs 10,000 on your decision. Don't be surprised. This happens to everyone. And, very often.

Buying at Rs40 would have clearly been the smarter thing to do. Unless, the stock's heading to Rs35. The lesson here is 'dead sure' doesn't exist and stock prices (or for that matter, bonds, mutual funds, or anything that has a price) go up and down.

At what price do you buy? Where's the bottom?

Nobody knows, not even your broker. But there is a way around these issues. And it is a strategy that most smart investors adopt. No, it is not complicated. In fact it is quite simple, most practical and could be quite profitable too. Especially, if you are an individual investor.

Let's see how it works.

Instead of investing your Rs50,000 in one lump sum, suppose you had invested a fixed sum of Rs10,000 at the beginning of every week. Your first Rs10,000 would have bought you 200 shares at Rs50. Your second of Rs10,000 would have allowed you to benefit from the lower share price and you would have bought 250 shares this time around, given that the price was down to Rs40. To understand how this investing approach works, refer to the table below. The table depicts likely stock price movements.

 

 

 

 

Dollar cost averaging
Period	Share Price (Rs)	Amount Invested (Rs)	Shares Bought
Week1	50	10,000	200
Week2	40	10,000	250
Week3	35	10,000	286
Week4	45	10,000	222
Week5	55	10,000	182
Total <		50,000	1,140

 

 

 

 

 

 

 

In the above example, by following this strategy you would have ended up owning 1,140 shares of Unbeatable Software Ltd as against 1,000 shares if you had bought in one lump sum investment.

The difference is significant - your Rs50,000 goes a bit further. In fact, 140 shares further. This approach of spreading out your investments over time and investing a fixed amount periodically is referred to as Dollar Cost Averaging. The important principle here is that you should invest a fixed amount (dollars, rupees, whatever) and not a fixed number of shares.

The above example represents a fluctuating market. While this approach will clearly further increase the number of shares you own with the same Rs50,000 in a one-way downward trended market, you would lose out in a rising market. But then, none of us can predict short-term price movements consistently and perfectly time ups and downs. Which is why this approach will work quite well most of the time. Basically, Dollar Cost Averaging helps you smoothen the market fluctuations to your advantage and removes the uncertainty of answering the question - At what price do you buy?

The psychological attitude to adopt in practicing Dollar Cost Averaging is simple. If prices are falling, you are better off; if they are rising, Dollar Cost Averaging is the price you pay to minimise losses should the market have gone the other way.

Remember, Dollar Cost Averaging - 
1. works equally well for both buying and selling decisions

2. increases your potential gains when acting against the market trend

3. reduces risk when you are playing the market trend

4. can effectively convert a regular savings plan into a regular investing approach

5. helps you to adopt a disciplined approach to investing

6. relieves you from the pressures of forecasting tops and bottoms