Dollar Cost Averaging Basics

The reduction of risk through the systematic and periodic purchase of securities is often referred to as dollar cost averaging. The purchase of these securities is done in certain amounts. Many investors already manage to apply dollar cost averaging and enjoy great successes. If you haven't still realized the benefits of this technique of risk reduction, read this article to find the basics that will guide you through the main steps required to design a plan. Pay special attention to the given examples in order to understand the practicability of dollar cost averaging.

Dollar Cost Averaging Essence

The main technique used in the dollar cost averaging is the incremental investment in assets over long periods of time. Instead of making a one time lump investment, by applying this tactic the investor manages to spread the cost basis over a long period of time and thus insure himself/herself against large caused by drastic changes of prices.

Dollar Cost Averaging Plan Establishment

Stick to the following simple steps in order to successfully design your dollar cost averaging plan:

Step 1

You should first determine how much you are willing and able to allocate every month, so that you clarify for yourself the money you will be capable of contributing to the investments. If you fail to stick to the pre-determined amount your plan may suffer and as a result will lose its efficacy.

Step 2

The next thing you should do is to choose the investment you are going to put your money in. you should view this investment as a long-term one, meaning you should assume that you are to hold it between five to ten years. We recommend the investment in index funds.

Step 3

The final step includes the regular investment (preferably weekly, monthly or quarterly) in the chosen securities. In order to automate the process, ask your broker if it is possible to make an automatic withdrawal.

Dollar Cost Averaging Plan Model

The following example provides an illustration of a typical dollar cost averaging plan.

Let's assume that John possesses $10,000. He decides to invest them in the beginning of 2002. John is facing the dilemma of either making one-time investment of the whole sum or making a dollar averaging cost plan. He takes the advice of his broker and sets his mind on the latter option. He decides to invest $1,250 each quarter for the following two years.

At the time he made his investment the price of a stock was $45.80. If he has decided on a lump sum investment, he would have purchased 218.34 shares. Unfortunately, the stock market experienced a decreased after two years, which would have made John's investment worth $2,210, since the price per stock dropped to $10.12.

Fortunately for John, he has taken under consideration the advice of his broker and has chosen the dollar averaging cost technique. As a result over the two year period he has accumulated 643,84 shares. Even though John still experiences a loss due to the lower closing price (the amount of his holdings will be $6,516), as small increase as $5.41 (making the price to $15.53) is enough for John to break even. This is significantly lower than the price that would have to be accomplished if he has chosen the first alternative.

If the market has recovered to its previous price of $45.80, John would have enjoyed a $19,489 profit. This is due to the lower cost basis that John incurs.

How did we compute the profit?

We subtracted the average cost basis from the selling price to get the profit per share. Then we multiply the profit per share by the number of shares John possesses to get the total profit he gained.

$45.80 (selling price) - $15.53 (average cost basis) = $30.27 (profit per share) x 643.84 (shares) = $19,489 (total profit)

Our Recommendation for Most Beneficial Dollar Cost Averaging

In order to get the best of dollar cost averaging you should combine it with diversification. Index funds provide for this opportunity. They represent passively managed mutual funds that imitate the movement of such indexes as the Dow Jones Industrial Average, the S&P 500 and others. If for example an investors decides to put his/her money in an index fund, s/he will automatically get a fractional interest from every one of the thousands of stocks that constitute the index that is being mimicked by the index fund. Aside from diversification, investors benefit from investing in index funds through the lower management fees since they are passively managed. In this way the investor saves money, which can be used for further investments.

The combination of a dollar cost averaging and index fund investing is extremely beneficial since the first greatly alleviates the market risk, whereas the second alleviates the risk specific to the company. This combination is suitable for those who intend to accumulate a long-term wealth by investing a portion of their portfolio in equities.

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