Financial Concepts: Dollar Cost Averaging

The concept of buying at a market low and selling at a high point is straightforward; it ensures maximum profit. However, timing out the fluctuations of the broader market or an individual stock turns out to be incredibly tricky. Even experienced and professional investors have a difficult time picking bottoms and tops in the market. This is one reason why many investors turn to dollar cost averaging (DCA).

Don’t let the terminology fool you; DCA is actually a simple and useful strategy for investing. Dollar cost averaging refers to the process of buying (irrespective of share price) a fixed dollar amount of a particular investment on a periodic, regular schedule. Because the dollar amount does not change, this results in fewer shares being purchased when prices are high, and more shares purchased when prices are low. Over time, the cost per share tends to average out. Through this process, an investor reduces his or her risk of investing a large amount in a single investment at the wrong time.

Here’s an example to help illustrate DCA. You receive an inheritance which leaves you with $10,000 to invest. Instead of taking that lump sum and investing it in a mutual fund or a stock all at once, DCA would suggest that you spread the investment out across several months. You might decide to invest $2,000 per month for the next five months, and this would then “average” the price of the security you invest in over that time period. For one particular month, you might buy while the stock is priced high, and the next month you might get more shares because the price is lower, for example.

DCA is a strategy that also benefits investors who don’t begin the investment process with a significant sum of money to invest. If you are able to invest smaller amounts regularly, you can ensure that you take advantage of growth over the long term. DCA is not perfect, however. Dollar cost averaging can’t prevent a loss in a market which is suffering from steady declines. Still, over the long term, this strategy tends to be an effective one.