Dollar cost averaging sounds like a terribly complex term, but we’re going to break it down and make it very simple for anyone to understand. In a nutshell, dollar cost averaging is buying an investment little by little over a period of time. Now that doesn’t sound so complex does it?
Dollar Cost Averaging: A Little More Detail
Now that you have the general idea, we will expound on that principle a little bit. When we say buying little by little, that means that the investor has a system in place of buying at certain timing intervals. For example, some people buy weekly, monthly, or even quarterly. They generally have a set amount that is going to be invested over a period of several months or even years.
Why Dollar Cost Average?
The idea is to reduce the risk to the investor. By making small purchases over an extended period of time, the investor creates a buffer of protection against changes in the market price. Let me illustrate this with an example:
Let’s say that stock A is selling for $20, $22, $17, and $16 respectively each quarter that you purchased 100 shares. That gives you an average price of $18.75, which is the price the stock would have to return to in order to break even. However, had you bought all 400 shares at $20, you would need to have the price return to $20 per share to break even.
While dollar cost averaging with a single stock is obviously a wonderful tool to protect yourself, there is an additional measure of security that you can implement as well. Try dollar cost averaging with mutual funds. A mutual fund is basically a fund that spreads the investment over a myriad of stocks, which will throw diversification into the picture. You’ve heard the phrase, “Don’t put all your eggs in one basket.”
How to Implement the DCA Strategy
A written plan is always the way to go when you are implementing any strategy.
- Determine the amount of money that you intend to invest and the systematic interval. Make sure that it is a realistic amount that you will be able to fulfill.
- Decide what investment that you want to put your money into. Make sure that it is something that you will be willing to hold onto for five to ten years.
- Regularly buy your selected investments. If you use a broker or mutual fund company, and they offer automatic purchases or an automatic investing program, it may be a good idea to use it. This will keep you faithfully adhering to your timing intervals.
That’s dollar cost averaging! If you notice, this is an investment strategy commonly used when you invest in a 401k or other employee retirement plan. Your 401k account can be set up to automatically deduct money from your paycheck on a regular basis for investing in stocks or mutual funds that you’ve selected. This is just one more tool to use in your investing career.