The Pitfalls of Dollar Cost Averaging

For example:

I bought 100 shares of Microsoft at $34.00 a year ago, making my investment in Microsoft $3,400 (100 shares @ 34 = $3,400).

Now, suppose today that the price of Microsoft is just $17.00 and I have $3,400 more to invest. I buy 200 additional shares, increasing my total holdings to 300 shares (200 shares @ 17 = $3,400).

Since my total investment is $6,800, my average purchase price is now only $22.67 (6800 / 300).

The Psychology of Dollar Cost Averaging

In our example, we would look at our Microsoft holdings (before dollar cost averaging), and say - this stocks needs to double its price before I can make any profit on it. However, after dollar cost averaging, the stock needs to go up just 5.67 per share before I start to make money. This is a very heartening feeling, and one I’ve done several times. However, if you are averaging just for this warm feeling, then you need to take a hard look at the opportunity costs.

Opportunity Costs of Dollar Cost Averaging

Opportunity cost is what you forgo in order to get something else (economists call it the value of the next best alternative).

For instance, if what I really wanted to do with my second $3,400 was buy Apple stock (trading at $80) instead of Microsoft, the opportunity cost of my decision is the Apple stock. Since $3,400 translates to about 42 Apple shares, the opportunity cost of 200 Microsoft shares is 42 Apple shares.

As long as both Apple and Microsoft grow at the same rate, it doesn’t make any difference to me. It is only when Apple appreciates quicker than Microsoft do I get affected. This is key because stocks that fall tremendously may not rise as much as the rest of the market. The very fact that they fell so much shows that something is wrong with them.

The Only Reason to Dollar Cost Average

There is only one reason that justifies dollar cost averaging.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.


Should you Dollar Cost Average?

Next time you are tempted to buy more stock to bring the average cost down, ask yourself one thing. Am I doing this for a warm feeling or is the stock a steal at this price?

If you answer this question honestly, you will get it right much more often.



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