Dollar cost averaging
If you're interested in building your investment portfolio gradually, you may want to consider a popular investment strategy called dollar cost averaging. When you use this approach, you invest the same dollar amount every month or every quarter in the same fund or company.
Because you invest regularly — perhaps by arranging for direct deposit as a payroll deduction or from a bank account — you're providing a regular cash infusion to build your account value. And by investing through the markets ups and downs, you can avoid paying only the highest prices.
Here's how it works: The price per share will tend to move up and down over time. When the price is up, you buy fewer shares with your investment dollars. And when the price is down, you buy more shares.
For example, suppose you invest $100 a month in mutual fund A. Here's a four-month snapshot of what you'd buy:
| Month 1 | Month 2 | Month 3 | Month 4 | |
|---|---|---|---|---|
|
Amount invested |
$100 |
$100 |
$100 |
$100 |
|
Price per share on purchase date |
$13.50 |
$15 |
$17 |
$14.50 |
|
Number of shares purchased |
7.4 |
6.67 |
5.88 |
6.9 |
In this case, you would have purchased 26.85 shares (7.4 + 6.67 + 5.88 + 6.9) for an average share cost of $14.90 ($400 ÷ 26.85) while the average share price was $15 ($13.50 + $15 + $17 + $14.50 ÷ 4). The 10-cent difference doesn't seem like much, but over an extended period could allow you to afford a number of additional shares. In contrast, if you'd saved up your money and invested $400 in Month 3, when the price was highest, you would have purchased just 23.53 shares — again a small difference but one that could have a big impact over time if you always bought shares at their highest prices.
Making the strategy work
Dollar cost averaging is attractive, especially when the markets are strong and you can see that your account is increasing in value. But to allow this strategy work, it's important that you continue to invest even in periods when the market is down and the value of your investment may be dropping. If you stop buying when the price drops, you will have paid only the higher prices and won't reduce your average cost.
That doesn't mean you should continue to throw good money after bad if a fund or a company seems unlikely to recover. There may be a point when the wisest decision is to cut your losses. But understanding how the regular buying strategy can work in your favor may give you the incentive to ride out a market downturn.
The bottom line
Dollar cost averaging can be effective, and it does make investing easy, but you do have to remember that it doesn't ensure that you'll make a profit. And it can't protect you from losses in a falling market.
