Dollar Cost Averaging
When you dollar cost average, you invest the same amount of money in the same security on a regular schedule, month in and month out. You can dollar cost average automatically by setting up a regular electronic transfer from a cash account to make the purchase.
Here's how it works
In theory, you use dollar cost averaging in part because it takes the temptation to try to time the market out of the equation. If the share price is high, you simply don't buy as many, and if the share price is low, you're buying more shares while they're at their bargain-basement price. But of course, there's no guarantee you'll make money or even that you won't lose any.
Here's an example. You decide to buy $100 worth of Widgets 'R Us stock every month. The first month, the share price is $25, so you purchase 4 shares (not including trading costs). The second month, the price goes up to $33, so you purchase only 3 shares. The third month, the price drops to $20, so you scoop up 5 shares. Make sense?
When you use this tactic, which is sometimes called a constant dollar plan, you can benefit in three ways:
- Regular cash infusions, along with reinvested earnings, are used to buy more shares, which have the potential to increase in value over time. The added shares also increase the base on which any earnings are calculated.
- Investing automatically reduces the chance you'll forget to invest or that you'll use the money for something else.
- There's the potential you'll end up paying less per share than you would have paid if you'd invested using a less regular tactic, or in one lump sum.
Potential is the key word
Dollar cost averaging allows you to invest through thick and thin, when the share price drops as well as when it's steady or rising. For it to work as intended, you can't stop buying during a market downturn. That's something you have to resolve to do before you begin. The flip side is that you're getting more shares for your money. In the next phase of the market cycle, assuming the price moves back toward its earlier price and maybe higher, you will have added that group of low-priced shares to your holdings, bringing down the average total cost.
What happens if you buy only when the market is strong? Your average per-share price will be higher than it would have been if you'd kept buying during the down times. That defeats the point. Dollar cost averaging works best when there's a low transaction cost for making the recurring investments. That way, more of your money goes to purchasing new shares.
Like all tactics, dollar cost averaging has limitations. It's not a tool for choosing investments, and it's not a strategy for managing risk. It doesn't guarantee you'll have a profit, or protect you from a loss. But that's not why you use it. You want to get the lowest average cost per share. In that way, you may increase your net profit. Your investing experience will vary depending on market conditions and the securities you select.