What is Dollar Cost Averaging
Dollar Cost Averaging is a method known to investors who follow a strict investment plan for consistent purchases of stocks. It's when a person invests "the same" dollar amount every month for an extended period of time regardless of stock price.
Its explained like this..
Imagine the only amount you can afford to invest is $200 a month to purchase stock. You check the stock price of a company and see its trading at $43 dollars a share during the month of April. So you invest $200 into a stock that's trading at $43 a share and receive 4.6 shares for it. (see math below)
Math : $200 divided by $43 = a total of 4.6 shares purchased
*(we will round it to 4 just for the sake of an easier explanation)
Time moves on and now its June, and you have another $200 to invest, so you check the stock price again and seen its gone up to $52 a share. So when you make another purchase with the same dollar amount you used the first time ($200), you will only get 3 shares instead of 4 because the price went up from $43 to $52 a share. (The stock got more expensive this month, so it gave you less shares.)
The Fact that the stock price went up from $43 to $52 makes a big deal when you're buying stock, specially if you're buying them every month.
If the price goes up, the cost of ownership will get less. If the prices goes down, the cost of ownership becomes cheaper.
But you must also understand that if the price goes up, the entirety of your account will increase. So your account will be making positive gains when the stock price appreciates and grows over time, at the same time costing you more to own per share.
If the stock price drops, yes, the ownership of buying a share will become cheaper, but if the stock continues to drop over time, the value of your entire account will degrade and decrease if the price continues to decline.
The main priority in purchasing stock is to find a stock that appreciates. One that has a strong financial background that will steadily increase its value in the future.
But note, volatility or fluctuation will always occur. It's what I like to call, "the heartbeat" of the stock market world. So purchasing during specific times makes the difference between everything.
Many of us don't have the time to follow the market to make beneficial purchases during certain times, that is why the method of Dollar Cost Averaging is so effective because it gives you the chance to purchase stock whether the price is high or low during any given circumstances, so long as you are consistent with your purchases.
"Average" means the tally of many different numbers summed into 1, or also known as the average. So when you dollar cost "average"... your account will average itself based on the highs and lows of all your purchases and give you an average cost per share.
This cost per share will be the average cost between all the shares you purchased during those different times whether the price was high or low. It will determine if your account will be at a total loss or gain.
Now lets look at the same story, different scenario..
Its now August with another $200 to invest. And also the month our stock releases their earnings report. The entire enterprise came to the conclusion that earnings of the company fell short, so the stock plunged from $52 to $39 per share.
You, being the person who's using the dollar cost averaging method takes the $200 and invests it at the price of $39 while receiving a whopping 5 shares for the purchase. (you see what happened?)
You received more because the price was less.
If you choose to continue investing $200 every month no matter what the price is, then you are practicing a well known method that is famously known as "Dollar Cost Averaging" - DCA
The last statement
By practicing this theory, you are accumulating stock at different price levels changing your average cost and maximizing your capital gains, which is the name of the game. Make sure you reinvest your dividends by setting it on automatic to purchase more of your stock thus compounding your wealth as it grows. You must do your homework to take advantage of this program by searching stocks that have strong financial statements, strong management, and that pay continued dividends, steady or increasing retained earnings, and paying down their debt. Increases of retained earnings is synonymous with positive cashflow.
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