An alternative to investing all at once, dollar cost averaging is a popular technique for investing a fixed dollar amount at regular intervals – usually monthly or quarterly.
By investing continuously and systematically, this strategy takes advantage of market fluctuations over time to reduce the average share price you pay for the security.
Although the strategy can’t protect you from loss in a declining market or guarantee that your investment will gain, it does eliminate the need to decide when to invest, thus requiring no effort to “time” the market. However, since dollar cost averaging involves continuous investment in securities regardless of fluctuating price levels of those securities, you should consider your financial ability to continue purchases through periods of low price levels, such as in a down market like 2008. For this reason, dollar cost averaging becomes most effective when coupled with long-term investment goals, such as saving for your retirement in an IRA or a 401(k).
To be effective, dollar cost averaging requires you to invest the same amount of money in a particular security – a stock or a mutual fund, for example – on a regular basis. By doing so, your money will automatically buy more shares when the share price of the security is low and fewer shares when the price is high, thus generally decreasing your average price per share.
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However, every investor wants to “time” the market and “buy low and sell high.” Lump sum investors (ones who purchase an investment all at once or over a short period of time, usually a matter of a few weeks) try to time their security purchases and sales in an effort to do just that. When successful, they may realize greater profits in a rising market than investors following a dollar-cost averaging strategy. However, most simply cannot time the market and typically underperform in the long run.
However, lump-sum investing versus periodic investing isn’t that clear-cut. The problem for any investor, but particularly a lump-sum investor, is knowing when to buy and when to sell and properly timing his or her investment decisions. The market is not entirely predictable; if a lump-sum investor buys high and sells low, he or she will suffer a loss.
While a dollar cost averaging investor might also suffer a loss in a declining market, the loss may be less severe than that of his or her lump-sum investor counterpart.
Because a dollar cost averaging investment strategy buys more shares of a security as the price of the security declines, this strategy does offer some downside protection in a declining market. What’s more, as the market rebounds, a dollar cost averaging investor will “break even” (or realize a gain) more quickly than a lump sum investor counterpart who invested before the market started declining. That’s because the dollar cost averaging investor owns more shares (at a lower cost per share) than does the lump-sum investor.
At the opposite spectrum, in a rapidly rising market, a lump-sum investor will outperform a dollar-cost average investor who buys in gradually as prices rise. While most studies support a lump-sum investor in the long-run, a gradual dollar-cost average investment strategy reduces volatility and provides a solid plan for most investors.
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