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Dollar Cost Averaging

If you are at all familiar with investing or even have just begun to get interested, then you've probably heard of the eighth wonder of the world, "Dollar Cost Averaging". It has been purported to cure the sick, feed the hungry, and, of course, as a side effect produce tremendous investment returns. To say the least, we think claims of its all encompassing power are somewhat exaggerated and misplaced. Dollar-cost averaging does not assure a profit or protect against loss in declining markets. Having said this, what it can do is help reduce your investment RISK, which is no small feat.

Essentially, dollar-cost averaging is a systematic investment plan under which investors make predetermined periodic purchases of a fixed amount on a monthly, quarterly, or even yearly basis. The strategy protects your portfolio by forcing you to buy more shares when the market is falling and less shares when the market is rising. In the end (assuming markets increase over time), your cost per share is lower than the average price per share.

The true beauty or value of dollar cost averaging can be found in its cold emotion free structure and is often realized during a down market. Psychologically, when stock markets are falling investors find it difficult to buy more stock. Often, this is due to the tendency of investors to extrapolate the short term event (possibly a correction) far into the future. Indeed, when the market is rising, investors tend to believe it will go up indefinitely. Conversely, when the market is falling, we believe it will fall further, forever. At this point, many investors stop investing and wait for the market to rebound. In most cases, this is exactly the opposite of what should be done. In fact, investors should view lower market prices as an additional opportunity to buy more stock/funds. A dollar cost averaging strategy forces you to put aside your "gut reactions" and continue investing periodically no matter what the current market psychology. Now, this is guide of "buying on all market dips" will not work to perfection in all situations. Certainly, there have been prolonged downward trending markets (over 5 years) in the past. As a result, you may buy on a market dip which will proceed lower, however, over time the strategy has proven to be a worthy one.

Who uses dollar cost averaging?
Dollar-cost averaging is often used by investors who don't have lump sums to invest, but would like to accumulate an investment portfolio over time. Indeed, the strategy will also help to ease into the market investors with lump sums to invest, but who are afraid of entering the markets at one time or price level (often not a good choice).
An example of Dollar Cost Averaging:
An investor puts $100 a month into his/her investment account for six months in a row. As the share price of company XYZ fluctuates over time, the results are shown below. After 6 months, the average price the shares were bought at is less than the share price at the end of six months, even though the share price is the same as the original purchase price in month one.
Month Investment Share Price Shares Bought
1 $100 $10.00 10
2 $100 $8.00 12.50
3 $100 $5.00 20
4 $100 $10.00 10
5 $100 $16.00 6.25
6 $100 $10.00 10
Total amount invested $600
Number of shares owned 68.75
Average cost per share $8.72
Current share price $10.00

In the investment world, markets fall and markets rise. Choosing a perfect investment point is very difficult. Using dollar cost averaging will help reduce your risk over time by ensuring that you do not buy in at a market high or low.

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