DOLLAR COST AVERAGING

A strategy designed to combat the unknown elements of the stock market is called “dollar-cost averaging,” or DCA. When we discussed systematically investing over a period of time, we touched on DCA. Although we didn’t mention it specifically, DCA can provide a good means of getting your feet wet in the market without the potential headache of jumping in headfirst. The tenet of DCA is simple: By investing systematically over a long period of time, you will normally see that you have a lower average cost per share, which can help increase your overall return.

Because no one knows from one day to the next what the market is going to do, investing over several months rather than in one lump sum amount may be a better idea for those investors who are a little more squeamish about investing, or who have a lower risk tolerance. Employing DCA also means that you may wind up purchasing shares at their 52-week high, but you may also buy shares at their all-time low. Over time, the cost of the shares averages out, so that you are neither paying top dollar, nor are you paying bargain basement prices. But employing the DCA method doesn’t guarantee a profit, nor will it insure you against a loss.

Dollar-cost averaging is generally used for mutual funds, but may also be used within the subaccounts of annuities. Let’s assume that you want to invest a total of $50,000 in the XYZ Growth Fund, but you don’t want to do it all at one time. Rather, you wish to spread out your investment because you don’t know what the market is going to do. Therefore, you decide you want to invest $5000 per month for the next 10 months to make up your entire investment. By doing this, you will be purchasing shares at, presumably, 10 different prices, which could lower your average price per share, and thus, increase your potential for making a profit from this fund.

For investors who wish to invest in a lump sum, they need to be aware that they may wind up putting their money in at the height of the market, or they may be lucky enough to get in when the market is at a bottom point. This is not to say that one way is better than the other. That choice is up to individual investors and their levels of risk tolerance. If you, the investor, believe that the market will be going back up at the time you are ready to invest, then a lump sum investment may be best. However, if you are unsure about which way the market will go, then perhaps using DCA is the best idea.

Essentially, DCA is best for investors who have the cash flow to invest a set amount at regular intervals and aren’t prone to try and decide whether the market is going to go up or go down. This strategy also works the best for those who like to invest and hold a position for a longer amount of time. Either way, the worst situation is to not be invested at all.