Smart Investing with Dollar
Cost Averaging
Dollar Cost Averaging, or DCA,
is a technique where you purchase a fixed dollar amount of your
favorite investment at regular intervals, such as once per
month.
When prices are down, you will receive more shares. When prices
are higher, you will receive fewer shares. The idea is that you
will be able to take advantage of dips in the prices but also
minimize buying at higher prices. In the long run your average
share price will be somewhere between the highs and lows
throughout that time period, resulting in less volatility than
putting all your money into just one or two large trades.
This technique is very simple and can be set to run
automatically on many online brokerages such as ShareBuilder.
This is a great option for investors who do not have time to
sit at a computer every day watching for the perfect price to
come along.
Example Let's say two traders have $10,000 to buy Microsoft
shares.
Trader A decides to put half of
his money in right now at $28 per share, for 187 shares, and
half of his money next month at $30 per share, for 166 shares.
Overall, he purchased 353 shares at an average price of
$28.94.
Trader B decides to use DCA over a
4-month period, which is $2,500 per month. He receives 89
shares at $28, 83 shares at $30, 96 shares at $26, and 92
shares at $27. Overall he purchased 360 shares at an average
price of $26.67.
In this case, Trader B came out on
top, purchasing 2% more shares at nearly 8% less than
Trader A. That won't happen in every case, but you get the
idea.
Why it Works Since the markets
have historically gone up over the long run, buying shares at
regular intervals over the long run should go up too. DCA
should reduce the effect of volatility in the prices throughout
the year, but it will probably reduce your chances of large
gains. This is the classic tradeoff in investing of risk versus
reward.
Further Diversification Any single
stock has the potential to "bomb" on you, causing massive
losses. One great way to reduce this risk greatly is to trade
mutual funds, which often spread out your money over hundreds
of different stocks. Combined with DCA, you should have a
relatively safe and easy investment strategy.
Disclaimer This technique is not
guaranteed to make you profits or eliminate the risk of losing
money. It is really just a way to average out share prices. For
example, if a stock is dropping in price every month, your
average price will be lower and lower, resulting in a loss
overall.
About the author: Nicholas Swezey
is the creator of the free
href="http://www.howthemarketworks.com
">Stock Market Game at
HowTheMarketWorks.com.
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