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Author: ORWAHOO Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: Dollar Cost Averaging Rationale Date: 5/29/1997 7:52 PM
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There seems to be some confusion over what Dollar Cost Averaging (DCA) is. Yes, its strengths are evident in DRIP programs and when investing income over a period of time. But, it is also a prudent method of investing a large sum of money into a market that is high by many standards. By using this strategy, I plan on protecting the portfolio from a big hit if the market takes a severe dive in the near future.

For the sake of simplicity, let's just say I'm going to buy one type of stock -- SPY, aka Spiders, which mimic the S&P 500. Let's also, to make things shorter, cut the number of stocks I buy to 6 (one a month for 6 months) and the amount to be invested to $60,000.

In reality, like I said in my earlier post, I am going to buy a number of different stocks. But this example will be valid assuming that the portfolio (and the individual stocks to be bought) will rise and fall as the market does.

Today, SPY is trading at $85. If I were to invest all $60,000, I would own about 705 shares (excluding trading costs).

But, if I dollar cost average:
Month Price of SPY Shares Bought
1 85 117
2 87.55 (3% rise) 114
3 83.17 (5% drop) 120
4 79.01 (5% drop) 126
5 76.64 (3% drop) 130
6 80.47 (5% rise) 124
-------------------------------
Total shares bought: 731

In all, this represents a slightly choppy 6 months, ending up with a 5.32% overall drop in the market -- not a completely unheard of drop over a 6 month period. Certainly this market -- any market -- has the ability to drop 10%, 15%, 20% or more in any given period. I chose to use a less severe example.

The DCA method gives the portfolio 3.68% more shares of the stock. So, at the end of the 6 month period, through DCA, the portfolio would be worth $58,823 (or a 1.96% loss), while the invested-at-once approach would be worth $56,731 (5.45% loss). By the way, the discrepancy between the market loss and the all-at-once port loss is explained by rounding off the number of shares bought. You can see, though, how the DCA approach protects a portfolio from a down market.

This method does not work in a market that rises steadily. Rather, it is a conservative way to invest a lot of money into a high market. This is a gamble I'm willing to take with money my father may need in his retirement.

Another thing that some posters brought up is that I would incur too much in the way of trading costs. This isn't a valid argument in my case. I'm going to be buying 14 blocks of different stocks in a $100,000 portfolio at about $20-$30 per trade whether I buy them all today, or I buy one block a month for the next 14 months. The argument might have some validity, though, in the above example where the same stock (SPY) was bought, and if you don't "believe" in DCA. But, the trading costs in my father's portfolio will only amount to about 0.35% of the portfolio -- in the first 12-18 months. That's not too high of an expense ratio. And, I "believe" in DCA.

I hope this clears up some confusion about what DCA is and why I'm using it.

My original post here was to clear up some tax questions, and for that, I thank TMF Taxes. As for DCA, you can disagree with me if you know FOR CERTAIN that the market will continue this torrid pace, unabated, for the forseeable future. Since nobody in this universe can give me the correct answer on the future of the market, I'll have to make a judgement call on whether or not to use DCA. Frankly, I think it's a prudent thing to do.

Thanks for letting me explain myself.
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