Dollar Cost Averaging

Quick Summary of Dollar Cost Averaging

Dollar-cost averaging is the discipline of regularly buying shares of stock. An investor using this long-term technique would invest a set amount every month, as opposed to saving it up and investing it in one lump sum.

Dollar-cost averaging is a long-term investment strategy in which a fixed dollar amount is added to an investment on a regular schedule, regardless of the market price of the security.

Dollar-cost averaging is also called a constant dollar plan. Since an investment’s share price fluctuates, by following a dollar-cost averaging strategy, more shares are bought when the share price is low, and fewer shares when the share price rises. Over time, dollar-cost averaging results in a lower average cost per share than a plan that involves purchasing an equal number of shares at each interval. Dollar-cost averaging is a popular way to invest in mutual funds, and investing regularly through dividend reinvestment plans is a form of dollar-cost averaging. While dollar-cost averaging reduces the risk of investing a lump sum in a single investment at the wrong time, dollar-cost averaging does not guarantee the investor a profit.

This technique is the complete opposite of market timing. With dollar-cost averaging, you automatically buy, let’s say, $500 of shares every month via a mutual fund or other investing vehicle regardless of what the market is doing. Your money will buy fewer shares when the price is high and more shares when the price is low.

You’ll end up paying low prices per share sometimes (yay!) and high prices per share sometimes (bah!), or miss out on the two-day plunge in the market (yay, again) or miss out on the two-day irrational spike (bah, again). One of its main advantages is that it is a set-and-forget strategy. In other words, you’ll buy $500 worth of the security each month, every month. You can even instruct your bank to fund the brokerage account on a set day, then instruct the broker to purchase the shares automatically a few days later. Now that’s set-and-forget!

Dollar-cost averaging can be a good strategy for those with not much money to invest. A small chunk can be allocated each month, and it could be taken directly from a paycheck so you never “see” the money and therefore don’t miss having it. The technique can also be useful for those with lots of money to invest.

Make sure to investigate the fees that will be charged. And, of course, Dollar-cost averaging is no guarantee of good returns. It depends a lot on what years you are in the market.

This technique works especially well for no-load mutual funds, where the purchase is made in dollar amounts rather than whole share amounts (like for a stock). But it can also be used for stocks by rounding down to the nearest whole number of shares (don’t forget the commission!).

A second main advantage is that it diversifies your purchases across time, so you don’t end up buying all of your position at the worst possible moment, just before a 50% drop or something. By buying a bit at a time, you’ll end up with some expensive shares, sure, but you’ll also end up with a set of cheaper shares, too. And when the stock price turns around, those cheaper shares will give proportionally larger gains.

Of course, dollar cost averaging must only be done with a security that you are completely comfortable with. It shouldn’t be so set-and-forget that you end up buying more and more shares of something that gets worse and worse. So keep paying attention to what you are buying.

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