Dollar Cost Averaging
Dollar cost averaging is one of the most popular ideas in the investment community. Everyone seems to like it and it has become a watchword among stock and mutual fund brokers. If it is properly done you will make money, if not you will lose money or at best stay even. Let's examine the basic premise behind this method of investing.
You decide to buy shares in Mouse Trap, Ltd.(symbol CHZ), a computer company that produces sophisticated hardware. The shares are now selling for $40 and you want to purchase approximately $1,000 worth each month. Today you buy 25 shares. Next month the stock has gone up to $43 so your purchase is 23 shares (I'm rounding these off because you can't buy fractions of shares.) The following month it drops back to $40, you get 25 more. Then at $37, you have 27 shares. At $35, 28 shares. At $32, 31 shares. You have invested $6,000 and have 159 shares at an average cost of $37.75.
With the current price of the Mouse Trap at $32 you have a loss of almost $1,000 (159 X $32 = $5,088). The object of buying any stock or mutual fund is to have more money than you put in, not more shares and less money. Who came up with this anyway?
Many years ago a broker talked his client into buying a thousand shares of Gravy Train (symbol EZSt) at $50 per share. In 30 days Gravy Train had spilled down to $30 and the broker didn't want to tell his customer the bad news, but he had to call him so he came up with this: "Great news, Mr. Mushroom, Gravy Train is now at $30. If you buy another $50,000 worth you can get 1,666 shares and own all 2,666 shares at an average price of only $37.50. Isn't that wonderful!" So far a "wonderful" loss of $20,000.There is a basic rule I learned a long time ago as a floor trader: NEVER ADD TO A LOSING POSITION.
I am in favor of dollar cost averaging, but there is a right way to do it. Only buy more shares as the price advances. Each purchase should be at a higher price per share than the previous price per share. This applies to both stocks and mutual funds. One good stock can make you a very rich person; one bad one can put you in the poorhouse.
In 1996 one of the hot stocks was Boston Chicken selling in a range of $30 to $40 per share. You could really own a lot of these shares had you continued to pour in money. It currently is selling at 50 cents per share. And mutual funds are not exempt. Lexington Troika-Dialog Fund was $24 in 1997. Today it is $3.00 per share. If you had dollar cost averaged UP your only loss would have been your first purchase.
Remember the object of investing is to make money not own a lot of shares.