Dollar Cost Averaging
The Magic of Dollar Cost Averaging
It’s always been the same; it never changes. We can remember back in the 1970’s talking to brokers who would buy a stock for a client, and the stock would fall out of bed. If it still made sense to own the stock, the broker would tell the client to average down. So let’s take a hypothetical example. Your broker buys you a thousand shares of AT & T at $ 50 per share. The stock then goes to $ 20 per share. He tells you to buy another thousand shares at $ 20. Your average cost basis is now $ 35 per share. $ 35 is still one hell of a ways from the current price of $20. It looks like this:
- Simple Averaging
- 1000 shares ATT @ $50 per share = $ 50,000 1000 shares ATT @ $20 per share = $ 20,000
Total Cost $ 70,000
Average Cost ($70,000/2000 shares) $ 35 per share
After 30 years we can tell you that this is not the way to average your cost. The mistake that brokers make is that they have you buy the same number of shares at each price level. The magic of dollar cost averaging is that you put in the same number of dollars as your original investment at lower price levels. In the example above instead of buying a thousand shares at $20 per share, you would be buying $ 50,000 worth of ATT at $ 20 per share. $50,000 worth of ATT at $ 20 per share is equal to 2500 shares. Let’s take the example above.
- Dollar Cost Averaging
- 1000 shares ATT @ $50 per share = $ 50,000 2500 shares ATT @ $20 per share = $ 50,000
Total Cost $ 100,000
Average Cost ($100,000/3500 shares) $ 28 per share
Instead of generating a cost basis of $ 35 per share, you now have a cost basis of $ 28 per share. This is a very important concept we are pointing out to you. If you want to see this concept work big time, then let’s look at Lucent Technologies. The stock is down from $ 84 per share. Let’s say you bought 1000 shares at $ 80 per share. Your cost for the 1000 shares would be $80,000 The stock then went to $ 5 per share. Using dollar cost averaging, you would buy $ 80,000 worth of Lucent at $ 5 per share. That’s 16,000 shares folks. Look at the example below to see your new average cost.
- Using Simple Averaging
- 1000 shares Lucent @ $80 per share = $ 80,000 1000 shares Lucent @ $5 per share = $ 5,000
Total Cost $ 85,000
Average Cost ($85,000/2000 shares) $ 42.50 per share
- Using Dollar Cost Averaging
- 1000 shares Lucent @ $80 per share = $ 80,000 16000 shares Lucent @ $5 per share = $ 80,000
Total Cost $ 160,000
Average Cost ($160,000/17,000 shares) $ 9 per share
As you can see, if you used simple averaging which is what 99 percent of the brokers in America recommend, then your average cost is $ 42.50 per share. On the other hand if you employ Dollar Cost Averaging, you bring your Average cost down to $ 9 per share which is very close to the actual low of $ 5 per share.
There are a couple of things you have to think about before you utilize this concept in your investment thinking. They are:
- You better be sure that this stock is coming back, or you will get your clock cleaned You have to be absolutely comfortable with your knowledge base concerning the stock in question, or you will be scared out at the bottom. This means you will be selling, instead of buying the stock
You have to have the cash to play in this arena. This is why you never ever go on MARGIN. Margin kills
As part of point 3) above, always keep some dollars in reserve.
