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Dollar Cost Averaging

By Edited May 8, 2016 2 1

Dollar Cost Averaging is a technique used in investing to purchase securities like stocks, mutual funds, and other investment instruments fluctuate in price. The idea is that you spread your purchase over time so that you don't run the risk of investing all of your money at a time when prices are particularly high. A huge benefit of dollar cost averaging is that it tends to result in a lower cost per share than if you invest all at one time. Of course, if you happened to invest your money all at once at a time when prices are at their all time low, you can't beat that, but that scenario is extremely unlikely.

Two critical questions remain, then. First, how does dollar cost averaging lower your price per share? Second, how do you carry the technique out in practice?

The way dollar cost averaging works is that you invest the same amount of money, on a consistent basis, spread out over time. For example, if you have five thousand dollars to invest, and you wanted to buy a specific mutual fund, you could spend all of your money and buy it all at once. Why not do that? There are a couple of reasons. One is that you may not have a lump some of money right now. You might want to invest a bit of money each time you get a paycheck, or after you receive some periodic payments. The main reason, however, is the risk that comes with market timing. Unless you possess an accurate crystal ball, you can't be certain that you are not buying it all at a particularly high priced time. By dollar cost averaging, you reduce the risk of any single particular day and time.

You might be thinking, "OK – I get it, I don't want to buy it all at once. But – what is wrong with just buying, say, a hundred shares now, a 100 shares later, and another 100 shares after that until I have invested my money?" Well, that does help some, but there are hidden advantages to dollar cost averaging compared to that scheme.

With true dollar cost averaging, you invest the same amount of money at evenly spaced intervals. Your interval isn't critical and as long as it is spread out. Thus, you could invest a given amount once per month, once per quarter, once per paycheck, or whatever makes sense for your cash flow and individual circumstances.

How is dollar cost averaging advantageous over just buying the same number of share each time? With dollar cost averaging you are automatically buying more shares when the price is low and less shares when the price is high. Remember the goal is to buy low and sell high. This article is about helping you to buy low.

With dollar cost averaging, since you are buying the same dollar amount each time, if the price is different, then you are buying more shares when the price is lower than you are when the price is higher. Pretty amazing. Among other advantages, it brings a discipline to investing, and provides a concrete roadmap to follow. If someone has committed to dollar cost averaging, they are less likely to start buying in a frenzy with the crowd when the price is rising (thus buying when the price is high) or getting discouraged and selling out if the price is sinking (thus selling when the price is low). If the fundamentals have not changed, and the purchase was a good idea in the first place, then you can view market dips as though they put your purchase "on sale" and a chance to get more at a good price. A more subtle problem when not dollar cost averaging is a natural tendency to simply not purchase when prices are falling. Some investors seem to say to themselves "Well, I'll hold the course through this downturn, but I'm not going to be putting in new money until things stabilize." That thinking means they will miss all the good sales!

An additional way to really take advantage of the discipline imposed by dollar cost averaging is to set up an automatic investment program where transfers are made automatically from your bank account or paycheck for a specific amount of money at a specific investment interval. Thus, dollar cost averaging can be considered in some sense a "set it and forget it" process. Of course, it is essential to keep tabs on your investments to make sure there aren't fundamental reasons to change your strategy or individual investment choices, but absent that, dollar cost averaging provides a reasonable mechanism for the individual investor.

Given the compelling advantages of dollar cost averaging, it is important to consider any disadvantages, or weaknesses with the strategy. The first weakness is that although the strategy is great for investing an ongoing income stream, it is less advantageous for investing a lump sum that you might have. It is still a good idea to dollar cost average, but then you are faced with the dilemma of what to do with the rest of the lump sum while you are waiting for each investment time. Another potential problem with dollar cost averaging are sales commissions. This is much less of a concern than it was in the past. In the past, every transaction you made generated a healthy sales commission with your broker. Thus, breaking up a transaction into many smaller transactions could be quite costly. Today, however, with discount brokers and online services, the transaction costs are quite reasonable.

In summary, dollar cost averaging is a technique that helps to impose a discipline in your investing, while reducing your average cost per share of your investment, whether it be stocks, mutual funds, or other investment vehicles.

This article is meant for informational purposes only regarding my opinions of one investment technique. This article is not to be considered investment advice. As with any investment or technique, you can gain or lose money. Always consult with an investment professional before making any investment.

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