One of the major problems facing individual and professional investors alike is determining when to buy a particular stock or, stated another way, how to find the bottom of a price swing.
This is the time to jump in and buy, since the price should only go up from this point. The problem is that no one is consistently correct in calling this point on individual stocks and certainly not on the whole market.
If you miss this point and the stock begins to move up, you have lost some of the potential gain by not buying at the right point. As I have said in another article, market timing is a dangerous game.
How Dollar Cost Averaging WorksDollar cost averaging solves this problem by eliminating the need to predict an entry point. Heres how it works.
The principle is simple: Invest a fixed amount of money in the market at regular intervals (usually every payday or every month) regardless of whether the market is up or down.
If you participate in a 401(k) or 403(b) retirement plan, you are already using this tool. These and other defined contribution plans use the strength of dollar cost averaging to build your retirement fund. Each pay period, your employer pulls a fixed amount from your salary before taxes and deposited in one or more special accounts, often mutual funds or annuities.
However, you can also take advantage of the power of dollar cost averaging in your individual investing program. The beauty of dollar cost averaging is that you buy more shares when prices are low and fewer shares when prices are higher. The result is an average cost that is better than trying to time the market with your investments.
Dollar Cost Averaging SystemThe system works because it takes the emotion and temptation to time the market out of the process. You establish an amount that is comfortable for you to invest and let the market do its thing. The system takes the decision-making elements of how much to invest and when to invest out of your hands.
The table at the end of this article shows what happens when you invest $300 per month for six months in an investment that fluctuates in price.
The average market price per unit = $48/6 = $8.00. Your average cost per unit = $1,800/255 = approximately $7.05.
I have exaggerated the price fluctuation to show how dollar cost averaging works because of space limitations of only showing six months worth of data. In real life, you might see this kind of experience over six years of dollar cost averaging.
The point of the example is you dont have to guess when to purchase shares to get a better price.
Will dollar cost averaging guarantee you a profit? No system can do that. However, if you buy quality investments and continue dollar cost averaging over a long period, you will have a much better chance of success than trying to get in and out of the market at the right times.
ConclusionDollar cost averaging is a powerful tool for the individual investor who wants to buy and hold a stock for the long term. It takes the emotion out of decision-making and, over time, gets you a better price than guessing when to buy.
Dollar Cost Averaging Table