Simply put, dollar cost averaging (DCA) is a stock purchasing plan that helps investors minimize the timing risk associated with lump sum investing. It is a strategy that is best used by investors with little time to watch the day to day fluctuation but still want to invest money in equities because it lets you set-and-forget your investment strategy, minimizing the time you need to spend study stocks and watching your portfolio. It certainly isn't a strategy loved by all, but it does have its benefits.
The way that this investing strategy works is to purchase stocks or mutual funds at a certain times during the year with a certain amount of cash. The traditional way to do it was to invest on the first day of each quarter of the year for an entire year. However, individual investor should not feel bogged down by this understanding of dollar cost averaging and should simply consider it an investment strategy that invests a certain amount of money at a fixed point in time.
You could dollar cost average $1000 by investing $20 on Tuesdays for 50 weeks. Or you could invest the same $1000 by investing $100 of the second Monday of every month. Whatever you decide to do it is still dollar cost averaging because you are investing your money at a predetermined interval and in predetermined amounts.
Another key characteristic of this type of investing is a fairly long investing horizon. Most experts recommend that you stick with this type of investment strategy for 7-10 years so that you can benefit from any cyclical down period in the economy as a whole. You will also benefit from the assumed upward trend of the market.
The main benefit of DCA is that is helps you avoid the dreaded "worst timing" scenario. This is the investment decision that we all fear when we start investing. It is that sudden dip in the market that turns our $5000 investment into $2500 in the course of single week. It could take years to recover from loses of this magnitude - and dollar cost averaging will help you minimize the impact that such a precipitous fall can have on your investment portfolio.
But DCA does have some negatives to it as well. The additional 'safety' that this strategy provides comes at a price - the ability to 'perfectly' time the market. This is that rare moment when you buy a stock at its lowest point and sell it at its highest. Though rare, a dollar cost averaging investment strategy completely obliterates your chances of perfectly timing the market.
It is also important to note that not every financial guru or academic thinks that dollar cost averaging is really that great of an investment strategy. They can question just how effective dollar cost averaging is at mitigating risks, so this strategy should definitely be carefully considered before implementing.
In the end, each individual investor is responsible for how they handle their own money. Dollar cost averaging is simply one tool in a very large tool shed. Getting educated about which investing tool is right for you is very important and will take some time and serious effort. Rest assured, this type of self education is worth every minute and every penny
09 February 2009 Article IT