Dollar Cost Averaging and its pitfalls
There are lots of theories, which have become plans, for how
to invest your money into the stock markets. One of the most popular is the plan of "dollar cost averaging."
Dollar Cost Averaging tells you to keep buying shares over time, and over time the average price of your shares
will be lower than the selling price in the future. Yes, this works very well if your stock price is higher in the
future than the average of all your purchase prices. For example, you buy ten shares a month at $10 each for the first
year, and then the second year you buy another ten shares a month at $11 a share. And then in the third year you sell
all of your stock for $12 a share. This is the ideal situation for "dollar cost averaging" -- when
prices rise over time.
But what do you do when stock prices are not moving up consistently, or they are stalled
or are even moving lower? Then, do you still want to risk "dollar cost averaging?"
This is when
another theory or plan comes into focus, and this one also has slogan you can follow: do not throw good money after bad.
This is not too difficult to undertand or to follow. If you have a winning stock, you can keep buying shares of that
stock as it rises, and hopefully down the road the selling price will be higher than the average of your buying prices.
This is dollar cost averaging at work, again.
But what if the stock you are buying is going down in value each
time you go to buy more shares? Then you are "dollar cost averaging," but you are "dollar cost averaging
down" instead of dollar cost averaging up.
The problem with dollar cost averaging down
is that no one knows when a stock price has hit bottom. You could be buying shares as they go from twenty dollars
to fifteen dollars to ten dollars and never know when the stock has reached bottom.
Dollar cost averaging up
is an easier and simpler strategy. Only buy more shares in a rising stock.
Buying more shares of
a stock that is tumbling in price could simply be throwing good money after bad-- putting more money into an investment that
is losing.
If you are going to dollar cost average, do it in a stock that is going up in price--not in a stock that
is falling. That doesn't mean you have to sell the shares you already own, but it does mean you should hold off
on buying additional shares until the tide has turned, and the stock price is moving up again.
The same holds
true for mutual funds-- buy them as they rise in price, not when they are falling.
Yes, use dollar cost averaging,
but dollar cost average into a rising stock market, and not into a falling market. That's how I see it.