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Dollar Cost Averaging When Trading on the Stock Market

January 20th, 2015

What is Dollar Cost Averaging?

Dollar cost averaging is a technique that many financial gurus (not necessarily stock market gurus) try to push you into…especially if you’re a beginner investor. It entails averaging all your stocks together. The gurus push this technique by saying if you dollar cost average while the market is low, you will gain more when it rises.

This concept isn't right and it can lead to dangerous transactions and an incorrect view of the stock market as a whole.

What Could Happen If You Use Dollar Cost Averaging:

Let’s look at the example below:

100 Shares @ $100 = $10,000

Now let’s say your 100 shares head lower to $75 / share.  The financial gurus that push dollar cost averaging will tell you to purchase more shares:

100 Shares @ $100 = $10,000 (original)
100 Shares @ $75 = $7,500 (new)

The stock keeps going lower, hitting $50 a share. You now have 200 shares and your advisor tells you to buy 100 more, on the premise that this stock will eventually rise higher:

100 Shares @ $100 = $10,000 (original)
100 Shares @ $75   = $7,500   (original)
100 Shares @ $50   = $5,000   (new)

The stock goes lower and lower.  Over time you accumulate 1,000 shares total:

100 Shares @ $100 = $10,000
100 Shares @ $75   = $7,500
100 Shares @ $50   = $5,000
100 Shares @ $40   = $4,000
200 Shares @ $30   = $6,000
200 Shares @ $20   = $4,000
200 Shares @ $20   = $4,000

TOTAL: $38,500

You may think this scenario isn't probable, but look at the chart below:

GDP

 

ncs

They used to say GM could never go bankrupt, but it did. There are numerous reputable large companies that have gone lower and lower in their prices, and then never recovered. The market projects the best of the best.  If a company doesn't show future projected growth, the stocks may never move back up.

The Better Way to Dollar Cost Average

If you want to do dollar cost averaging I recommend setting a hard stop. A stop is a number where you are going to get out of the stock if it goes lower than that number. Let’s say your hard stop is $95 and we are going to dollar cost average up.  As your $100 stock goes higher and higher, you add a few shares at $120 and a few more at $150.  You’re dollar cost averaging up, and as you do this, you are going to raise your stop each time, say from $95 to $103 to $108 and so on.

If you stock lowers and gets to your new stop, GET OUT.  No ifs, ands, or buts. Don’t rearrange your stop to let yourself go lower, get out at the stop you set.

This is a safer route to dollar cost averaging. If your stock is heading lower, and you don’t get out at your stop, then you could get stuck with a lot of bad stock.

Last, always be mindful of you what you’re doing. My recommendation is to dollar cost average up if you decide to do dollar cost averaging. Set your stops and constantly raise it while buying on the tiny dips (not the big dips) in the stock. Don’t let your emotions play you into changing the plans you made when you weren't emotional.

Author: Sasha Evdakov

Sasha is the creator of the Tradersfly and Rise2Learn. He focuses on high-level education speaking at events, writing books, and publishing video courses on business development, internet marketing, finance, and personal growth.

I'm Sasha, an educational entrepreneur and a stock trader. In addition to running my own online businesses, I also enjoy trading stocks and helping the individual investor understand the stock market. Let me share with you some techniques & concepts that I used over the last 10+ years to give you that edge in the market. Learn More

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