April 4: Reducing Market Risk with Dollar Cost Averaging

by David Jenyns on April 4, 2007

The measured purchase of securities and stock at predetermined levels is called dollar cost averaging. This practice may be something you, as an investor, are already doing without realizing it. Rather than investing a large sum of money at one time, dollar cost averaging plans work to slowly buy smaller amounts of stock over a longer period of time. This way the cost is spread out over several years and protects investors from changes in market price.

Dollar cost averaging eliminates having to play the risky game of market timing. In other types of investment strategies, you wait until your desired company has a low stock price meanwhile hoping that the stock will increase in value. You do not want to invest in stock that is on its way down, yet at the same time you donít want to buy high only to have to sell low later on. Determining when to buy your stock and find the bottom of a price swing is complicated and based on speculation. Dollar cost averages removes the hassle and presents a solution for longer-term gains.

Dollar cost averaging works by investing a fixed amount into a security or stock per pay day or month, regardless of the stock price. In bull times and bear times, you buy your stock at the market price.

Many are unaware, but 401(k) plans operate on this same principle. Defined contribution plans such as 401(k) and 403(b) plans use dollar cost averaging to build retirement funds. Each pay period, the employer takes a certain amount of your salary before taxes and deposits in one or more accounts. These accounts are often mutual funds or annuities.

Dollar cost averaging also helps take the emotion out of playing the market. The established amount comes out of your account regardless of the market price. You simply let the market fluctuate as it will, and you invest your money regularly.

There are three simple steps to setting up your own dollar cost averaging plan. First you must decide exactly how much money you can afford to invest each month. Decide on this figure carefully because this is an amount that you need to be able to contribute to your plan on a long-term basis. It is okay if you want to increase the amount later, but for the time being pick an amount that is manageable for a long period of time. Secondly, you need to select an investment that you want to hold for the long term. Ideally, you want to hold this investment for five to ten years, or perhaps longer. Pick something that has been around for a while such as a well-established company or an index fund.

The third step in the plan is making investments into the security that youíve chosen. This is done on a weekly, monthly or quarterly basis. It is best to set this up as an automatic withdrawal if possible.

For example, letís say you choose to invest $300 per month for six months. The first month, the shares are $5 so you are able to buy 60 shares. The next month shares are up to $10 and you purchase 30. The third month shares are $6, and the fourth they are $12. In the fifth month of your investment plan shares are $10 and in the final sixth month they cost $5 per share again. Over this six-month period, you are able to buy a total of 255 shares for $300 per month. The average price of the share during this time it is $8 when you divide the combined costs of individual shares by the number of months ($48/6). However, with your dollar cost averaging, you only paid $7.05 per share when you divide the total amount spent by the total number of shares purchased ($1800/255).

The price fluctuation is exaggerated in this example to show how the process works. The benefit of using dollar cost averaging is that you donít have to guess when the shares will be at a low price. With traditional investing toward the example above, you might have avoided investing during the second, fourth and fifth months or you may have hoped that the $12 per share was a sign that the share would be rising soon.

Over a long period of time (in most cases much longer than six months) dollar cost averaging helps the individual investor gain powerful leverage in the market. With a dollar cost averaging plan, you can get a better price than guessing when to buy.

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