Timing the market is nearly impossible. There's almost no way to know what news a company will release the day after you've sold or bought its stock -- news that could send its share price up to the sky or down, down, down.
It's times like these when investment pros turn to dollar cost averaging, which is kind of like the investment equivalent to having your cake and eating it too. The same basic principle applies whether you are buying or selling an investment.
What Is Dollar Cost Averaging?
Dollar cost averaging sounds a lot more complicated than it is. The basics are:
- You invest a fixed amount in an investment at regular intervals.
- You buy more shares at a lower price.
- It's easy to budget for a regular investment.
- You can build a significant portfolio with this 'no-brainer' approach.
Why does dollar cost averaging work? By investing the same amount at the same time, you avoid the ups and downs of the market -- hence, the "average."
Buying Shares Using Dollar Cost Averaging
Dollar cost averaging is a smart way to think about purchasing securities. If you have in mind a particularly volatile stock or mutual fund, it can be hard to determine the best time to invest. One week it's up, the next it's down. It can feel like trying to time your entry into a double-Dutch jump-rope game.
That's why many investment professionals recommend buying small blocks of shares -- either of a particular stock or shares of a mutual fund -- at different times. That way, if a stock or fund is high one month and low the next, chances are you've gotten shares at each price. The end result will be that the average price you've paid for a security is neither the highest it's been nor the lowest.
Take the following example of a 100-share purchase of SuperComputer stock: The stock is trading at $20 a share, but you know from looking at its 52-week high and low that it's been as low at $5 and as high as $50. Should you buy now since it's lower than $50? Or should you wait and hope it drops back down to $5 or even lower? Using dollar cost averaging, you might buy 25 shares now and continue to buy blocks of 25 at different prices, hoping that the average price you've paid will be lower than $20 by the time you've bought all 100 shares. The table below shows how dollar cost averaging brought the average share purchase price down to $18.25.
Number of shares bought Share price when bought Value of shares bought 25 $20 $500 25 $30 $750 25 $14 $350 25 $9 $225 Total number of shares bought:100 Average share price when bought: $18.25 Total amount spent on investment: $1825
When the Taxman Cometh
Another benefit to buying at different times is that your investments will have different cost bases, or prices. An investment's cost basis becomes significant when it comes time to sell because the difference between your purchase price and the selling price determines your profit and therefore the tax you'll pay on the investment. The higher the profit, the higher the tax.
So let's say you've bought 10 shares of stock in BigCompany at $10, $15, $20 and $30 at various times. Now the stock is trading at $40. If you needed $400 (requiring you to sell 10 shares) and you opted to sell the ones you bought at $10, you'd have a $300 profit to report the next tax season. If you sold the shares you bought at $30, you'd only pay tax on $100. Dollar cost averaging can put you in a position to have multiple cost bases for one investment, giving you more flexibility when you consider the capital gains tax you'll pay in a given year.