04) Financial Concepts: Dollar Cost Averaging

by · October 6, 2010

Any professional investor will likely say that picking peaks and lows in the market is the most difficult call they have to make. Trying to time the market is a strategy that is extremely difficult.  Since buying when something is at an all-time low and selling at it’s utmost peak is almost impossible to do, many professionals teach about dollar cost averaging (DCA).

DCA, while sounding complex, is actually relatively easy and useful as a technique. This is the procedure of buying a fixed dollar amount of a specific investment on a regular schedule, regardless of the share price. What this means is that you buy more shares when the prices are low, but just a few shares when the prices are high. This ensures that cost per share over time will average out, thus, reducing the risk of investing a large amount in a particular investment at a wrong time.

Let us take an example: You recently got a $20,000 bonus for unrecognized excellenc! Instead of investing the whole amount into stocks or bonds, you invest the amount over a period of several months, say $4,000 per month. This averages the prices over the five months such that one month you may buy high, but the next month the prices are lower so you buy more, and etc.

This type of investment also works for investors who may not have that large of an amount to invest, but can invest small amounts on a regular basis. While this may not prevent a loss, it is an effective way of taking advantage of long-term growth.