A technique that drastically reduces market risk
When deciding to plan for the future, is it better to invest a lump sum, or would it be better to invest over a period of time? On balance, contributing over a period of time not only reduces risk, but also produces greater returns. The technique is known as dollar cost averaging.
Many successful investors already practice this without realizing it. Many others could save themselves a lot of time, effort, and money by putting a plan in place now.
Dollar Cost Averaging: What is it?
Instead of investing in a lump sum, the investor works their way into position by slowly buying smaller amounts over a longer period of lime. This spreads the cost basis out over several years, providing insulation against changes in market price.
Setting Up Your Own Dollar Cost Averaging Plan
In order to begin a dollar cost averaging plan, you must do three things:
- Decide exactly how much money you can invest each month. Make certain that you are financially capable of keeping the amount consistent; otherwise the plan will not be as effective.
- Select an investment or funds that you want to hold for the long term, preferably five to ten years or longer.
- At regular intervals (monthly or quarterly works best), invest that money into the plan you’ve chosen.
An Example of a Dollar Cost Averaging Plan
You have $15,000 you want to invest and the date is Jan. 1, 2000. You have two options: you can invest the money as a lump sum now, walk away and forget about it, or you can ease your way into the plan.
Had you invested your $15,000 in January 2000, you would have purchased 264.46 units at $56.72 each. When the fund closed for the year in December of 2002 at $13.69, your holdings would only be worth $3,620!
Had you dollar cost averaged into the fund over the past three years, however, you would own 746.21 units; at the closing price, this gives your holdings a market value of $10,216. Although still a loss, the fund must only go up to $20.10 for you to break even, not $56.72.
To go a step further, without dollar cost averaging you would break even at $56.72. With dollar cost averaging, you would have turned a profit of $27,326 when the fund hit that price thanks to your lower cost basis ($56.72 sell price – $20.10 average cost basis = $36.62 profit x 746.21 shares = $27,326 total profit.)
Example: Dollar Cost Averaging Plan
|Invest date||Amount||Price per share||Units purchased|
|Total||15,000||20.10avg.||746.21 units owned|