Dollar cost averaging is a method of investing where an investor invests a certain amount of money on a monthly or other consistent time basis instead of trying to time the market or buy a certain number of shares. This reduces the investor’s risk and averages out the price they pay for their investments. Rather than investing a large lump sum at one time, an investor can make smaller purchases over the long term which results in spreading out the cost basis and providing protection against market price changes.
For example, an investor may decide to invest $50 a month in a mutual fund. The number of shares that an investor can buy with the $50 will depend on the current price of the mutual fund shares. When prices are high the investor will only be able to buy a few shares, but when the price drops he or she will be able to buy more shares.
When done over the long term, dollar cost averaging helps to ensure that the investor is not always buying shares when prices are high. It takes a lot of the risk and guesswork out of investing. Instead of trying to always buy low or time investments, the investor diligently invests at regular intervals. This long term, steady approach can be quite profitable.
Many mutual funds and investment firms allow investors to use dollar cost averaging by setting up automatic investment plans. The investor can specify how much they want to invest each month and that amount can be automatically withdrawn from their checking account. The money is then invested into the mutual fund or other investment. By making this process automatic, the investor doesn’t forget to make purchases on a regular basis and derives the benefit of dollar cost averaging.
Getting started with dollar cost averaging is easy. First you need to decide how much you can afford to invest each month. Make sure you will be able to invest this amount on a consistent basis to take full advantage of dollar cost averaging. Next, you need to choose your investment. This should be an investment that you want to hold long term (at least five to ten years). Mutual funds are good investments for dollar cost averaging because it is easy to set up an automatic withdrawal. A mutual fund also gives you the advantage of diversification. Dollar cost averaging will help you to reduce your market risk and a mutual fund can help you reduce company specific risks. Combine that with steady, consistent investments and you build up a very nice investment portfolio.