Does Dollar Cost Averaging Work?

Dollar cost averaging (or a “constant dollar plan”) is an investing technique designed to reduce your investment risk. Rather than making a single large purchase, you invest a fixed amount of money at regular time intervals in a particular investment regardless of the current share price for that investment. It is viewed by many as a simple approach to investing that may enable you to increase the value of your portfolio while minimizing risk.

With dollar cost averaging, more shares are purchased when prices are low, and fewer shares are acquired at higher prices. The goal, over time, is that the average cost per share becomes lower. Dollar-cost averaging is seen as less risky compared to investing a lump sum in a single investment- potentially at a relatively high price. Under this approach, the investor seeks to guard against the risk that the stock (or other investment) may lose value shortly after purchasing by spreading his investment equally over a number of periods.

Does it Work?

Dollar-cost averaging offers its greatest advantage in uncertain, volatile markets, when prices are in flux rather than a sustained upward pattern. As the share price fluctuates, the investor purchases more shares at a lower price and fewer shares when the price is high.

In a bull market where prices are steadily rising, the best strategy may be to invest a lump sum rather than averaging out the investment. In this way, you are better positioned to take advantage of the steady rise in price.

For the average investor, who is unsure of the future direction of the market, it can be argued that the best strategy to minimize your downside risk is to arrange for regular and automatic investments through a dollar cost averaging approach. The investor should bear in mind, though, that in for the dollar cost averaging plan to be effective, you must stick with it and resolve to make the contributions at the regularly scheduled intervals.

A good article on dollar cost averaging

________________________________________________________________

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

« A Stock Calculator for Stock Profits | Home | The Basics of IRA Investing »