Dollar Cost Averaging Investment Strategy vs. Lump Sum Calculation
One of the popular methods of long term investment in stocks is the dollar cost averaging method. If you will invest your money using dollar cost averaging, you will be required to make installments at a certain amount and at a fix time period (example monthly).
For example, supposing I have $50000 to invest in stocks. If you are NOT using dollar cost averaging (so you are using lump sump method), you will simply invest the entire amount in a single transaction and let it stay there for a couple of years (25 months maybe) then reap profits after that.
Using dollar cost averaging, you will break down the $50,000 into several payments at a fix time interval usually monthly. Supposing I will commit to invest $2000 a month for stock X then it will take:
$50000/ $2000 = 25 months for the dollar cost averaging investment to mature.
Dollar cost averaging requires you to invest a FIXE D amount of dollars in a periodic interval (for example $2000 per month).Since the amount of investment is fixed and the stock price will vary (high or low); you will be purchasing more shares if the price is cheap and small amount of shares if the stock price is expensive.
Describing the calculation of dollar cost averaging method is best illustrated using an Excel spreadsheet such as shown below:
In the screenshot above, it is a 25 month investing period. The stock price starts at $2.69 per share on the 1st month and ends with $16.30 per share on the 25th month. A $2000 fixed investment has been made on a monthly basis. So the “shares to buy” will vary depending on the stock price:
Shares to buy = Fixed Investment/ Stock price
If you observed closely, when the stock price is still cheap; there are lot of shares bought compared when the stock price is expensive (towards the end of the 25th month).
The “cumulative shares acquired” is the summation of the shares bought on a month per month basis. For example, on the 1st month, I bought 743 shares and on the second month I bought 873 shares. The cumulative shares are now 1617 (743 + 873). Take note that on the 25th month (the time the dollar cost averaging investment matures); I bought a total of 8758 shares of stock X.
The cumulative stock value is computed by multiplying the “cumulative shares acquired” with the stock price. And the total value of my stocks at the end of the 25th month is $142751.
Since I invest $2000 per month, the total cumulative investment at the end of the 25th month is $50000. And in this case; when I liquidate all my stocks; I earn a total profit of:
Total profit = $142751 – $50000 = $92751
The % growth of the investment (x) is:
50000x + x = 142751,
50000(1+x) = 142751
Solving for x:
X= (142751/50000) – 1
X = 1.85502 or 1.85502 * 100% = 185.5%
What will be my profit if the entire $50000 is invested all at once on the 1st month (this is called lump-sum investing)?
Shares bought from $50000 investment on 1st month = $50000/$2.69 = 18588 shares
Value of 18587 shares at the end of the 25th month:
Total value of invested stocks = 18588 * $16.30 = $302984
Total profit= $302984 – $50000 = $252984
The % growth of investment using lump sum is:
X= ($302984/$50000) – 1
X= 5.05 or 505%
Conclusions and Recommendations: It does show that if you are sure stocks price will increase in the long run. And also you have the money ready to be invested as lump sum; then lump sum investment is a more profitable method and can make you more money than dollar cost averaging.
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