Dollar-Cost Averaging: Strategy of buying a fixed dollar amount for an investment on a consistent schedule, regardless of price. The strategy is meant to reduce the potential risk of market volatility.
Equity: A stock or any other security representing ownership.
The Constant Dollar Plan or Dollar-Cost Averaging
Let’s make the assumption you, as an investor, are 100% sure what equity you would like to purchase. We’ll call it Stock A. Now you have two options.
1) A lump sum investment. Simply buying as much of the equity you can at once. You plan to invest $10,000 and do so with one large trade.
2) Buying the equity in portions over a set time-frame. An example would be deciding to buy $1,000 worth of Stock A each month, for ten consecutive months.
In scenario two, you invest the same dollar value (total investment being $10,000) but spread the trades out over ten months. Over the ten month time span, Stock A’s price will likely change in value. Regardless of price fluctuations a $1,000 worth will be bought each month.
Let’s say Stock A posts higher earnings than expected, therefore increases in value during month three. But by month five, the stock crashes due to unforeseen circumstances. During month three you will have bought less shares and during month five you will buy many more shares.
Given this scenario let’s compare lump sum investing and dollar-cost averaging. For simplicity, Stock A only pays a single dividend a year and is not distributed during the time frame being examined.