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Saturday, December 15, 2007

Dollar Cost Averaging: Buy high, buy lower?

We ended the other day stating that DRIP's (Dividend Re-Investment Programs) allow us to automatically partake in a form of dollar cost averaging. In the U.K., dollar cost averaging is called pound cost averaging. What does this mean? What is Dollar Cost Averaging.

Well, you've probably often heard the expression: Buy low, sell high. That's the trick to trading right? Even when not trading, but investing, you want to buy lower when you accumulate good dividend stocks right? But when we are investing for the long term (Say, around 15 years or longer), we want as many shares as possible right?

But what sometimes happens? You buy at a price you think was low, but the market continues to drop. Is there a way to protect your investment portfolio when this happens?

Yes. Dollar cost averaging. When the market drops, you buy even more of the the stock at the lower price, at specific periods. Why? This averages out your position. Strict dollar cost averaging calls for the investor to buy at specific intervals, no matter what the market conditions are. In other words, you would buy every four months. No matter what the market conditions are. Over time, this helps average out the dollar amount of the shares you own. History has demonstrated that since the market rises, dollar cost averaging allows us to minimize our risk.

Let's illustrate it this way.

You buy 100 shares of stock XYZ at $50.00

It drops $7.00

It's still a good stock. Nothing has changed on their balance sheet. You are looking to own this stock for a couple of decades. Well, since that is the case, and you are being paid dividends on the stock you own, it would be a good idea (barring any bear markets or the like on the horizon). So what do you do? You buy 150 more shares of XYZ Stock at $43.00. Now, you're position isn't 250 shares at $50.00. You own 100 shares at a price of $50.00 ($5000) and you own 250 shares at $43.00 ($10,750) You lowered the average of your cost basis, and at the same time, you have more shares to be paid a dividend on. If your DRIP is on, then you accumulate even more shares. Then as, say 5 years passes and the stock price rises, you enjoy a higher rate of return, more shares, and a higher dividend pay rate since you own more shares.

Let's look at another example to illustrate what we're talking about. Let's take one of my favorite dividend stocks, Frontline Ltd (FRO). With dollar cost averaging, lets say you decide to buy FRO 4 times with in the year. So regardless of the market conditions, in February, you buy 40 shares at $33.00. Then you buy another 40 shares in May at $38.00. Then in July you buy another 40 shares at $48.00. Then in November you buy another 40 shares at $40.00.

What is your dollar cost average? $39.75

I used FRO specifically as an example to illustrate what can be a problem with typical Dollar Cost Averaging. You can actually raise your average over time, if you perform it at very strict intervals, regardless of market conditions.

So is there a way to introduce a bias into dollar cost averaging, so that we receive the benefits, and minimize the danger of actually raising our share cost average? Yes. I will discuss that in the next entry . . .

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