If an investor is employing the dollar-cost-averaging formula, she is investing the same dollar amount into the same investment periodically. The Series 7 will expect you to be familiar with this formula. Although dollar cost averaging is primarily used for mutual funds, people can use it for other investments as well.
Dollar cost averaging benefits the investor when the price of the security is fluctuating. The investor ends up buying more shares when the price is low and fewer shares when the price is high by depositing the same amount of money each time she makes a purchase.
Dollar cost averaging results in an average cost per share that is lower than the average price per share if the price of the fund fluctuates.
The following question tests your understanding of dollar cost averaging.
Mrs. Johnson deposits $1,000 into DEF growth fund in four separate months. The purchase prices of the fund are as follows:
Month 1: $40
Month 2: $50
Month 3: $50
Month 4: $40
What is the average cost per share for Mrs. Johnson?
(A) $40.00
(B) $44.44
(C) $45.00
(D) $48.35
The correct answer is Choice (B). On the surface, this question may look very easy to you and you may jump to Choice (C), but Choice (C) is the average price per share, not the average cost.
Remember that because Mrs. Johnson is investing the same amount of money each month, she’s able to buy more shares when the price is low and less when the price is high. In the first and fourth months, when the price was $40 per share, she was able to buy 25 shares each time. In the second and third months, she was able to buy only 20 shares each time:
Over the four months, Mrs. Johnson invested a total of $4,000 and purchased a total of 90 shares (25 + 20 + 20 + 25). The average cost per share is $44.44:
If you use your sense of logic and watch for ways to eliminate answer choices, you may get away with doing very little math. Here, you can answer the question by finding the average price per share, which is not what the question is looking for.
With dollar cost averaging, buying more when the price is low drives the average cost down; therefore, the average cost per share has to be between the minimum price per share ($40) and the average price per share ($45). The only number that fits these criteria is $44.44, or Choice (B).
You should be prepared to calculate the average cost per share, the average price per share ($45), and the amount saved per share ($0.56).
Fixed share averaging is a nice, easy concept that doesn’t require you to remember any more formulas. Fixed share averaging is just buying the same number of shares of a security every so often. Investors don’t get any savings with this type of plan like they do with dollar cost averaging, but it does force investors to be disciplined and consistent with their investing.