These two terms will be discussed under the context of strategies of investments of stocks and shares, and could be applied to in any particular stock, in any stock market and in any currency.
One of the maxims of good investment strategy is to “buy low and sell high”. However, nobody knows how low is low. Therefore, if the stock market is trending lower the averaging down strategy is to buy and to continue to buy, until there is an upturn. The reason being, is that the total average cost of investments per stock for an investor will trend lower based on this strategy. To illustrate the strategy in a simple example:-
Day 1 – Buy 1 share at US$ 200 per share
Day 2 – Buy 1 share at US$ 180 per share
Day 3 – Buy 2 shares at US$ 150 per share
Day 4 – Buy 3 shares at US$ 100 per share
The “average cost of investments per stock”, at day 4 is US$ (200+180+300+300), divide by 7 shares is US$140 per stock.
The logic is, that on average, the cost of individual stocks in a portfolio will drop as more stocks are bought when the stock market is falling, and when there is an upturn, the stocks could be disposed off if the price of the stock exceeds the “average cost of investment per stock” resulting in capital gains.
If the stock in the above illustration goes up to US$145 per stock, and all 7 stocks are sold, there will total capital gain of US$ 35 (US$5* 7).
Dollar cost averaging
Dollar cost averaging is a term for an investment strategy to invest a fix amount of money, in fixed schedule for a fixed term.
If an investor decides to invest US$100 a month on any investment, for 5 years, then this is a dollar cost averaging investment strategy per Wikipedia.
For example, the fixed amount of money for investment is US$100, the fixed schedule is every month, and the fixed term is for 5 years.
The logic is that regardless of whether it is a falling or rising stock market, this strategy will lower the average cost per share or per unit of investment over time.
For example, in a low or falling market, US$100 could buy 50 stocks a month; in a rising or a high market US$100 could buy me 10 stocks a month, on average the cost per stock will drop. If an investor continues to invest religiously over 5 years at US$ 100 a month and not worry about how many stocks or unit in total, on the average the cost per stock will fall.
At any time, when an investor wants to dispose off the stocks, whether it is a falling or rising market, capital gains will be made.
Difference between averaging down and dollar cost averaging
The main difference between the two investments strategies are that the parameters of a fixed investment of money, on a fixed schedule, over a fixed timed period is required for dollar cost averaging strategy. There are also claims that for the strategy to work, the dollar cost averaging strategy must be for the medium to long-term, where the stock markets are bound to rise and fall during the time frame.
Meanwhile, there are no parameters, or time frame for the averaging down strategy, except to buy stocks when the stock market is falling or when prices of stocks are low.
The objective of both strategies is to lower the average cost per unit of investment.