Dollar Cost Averaging

Dollar cost averaging is an investment strategy that has persevered through good times and bad despite having more than its share of opponents.  Understanding this practice will show you why it is used, how it can be useful, and why there will always be those who warn against it.  Once you understand it, dollar cost averaging may become part of your permanent investment strategy, or it may be something that you never consider again.

What Is Dollar Cost Averaging?

Dollar cost averaging is simply purchasing a fixed amount of an investment in terms of dollars regardless of what that investment is worth at any point in time.  The consistent dollar amount merely means that more shares are bought when those shares happen to be cheaper, and fewer shares are bought when the shares happen to be more expensive.  This method has maintained its popularity for a very long time because it is easy and predictable and is thought to be an effective strategy for building up one’s savings.

What’s The Alternative?

One alternative to investing smaller chunks at a time is investing larger amounts all at once.  Many point to potential market drops following larger investments such as these, but studies have shown that those who enter the market in this manner often outperform their counterparts who stick to dollar cost averaging.  But still dollar cost averaging wins out for many individuals.  This is largely because of either habit or the recognition that investing larger chunks of money brings with it increased risk.  This risk is especially relevant for those who don’t have the money to lose or the time to wait for the market to improve.

Why Is Dollar Cost Averaging Popular?

If this method has been shown to be outperformed by this other equally simple investment strategy much of the time, then why do investors persist with dollar cost averaging?  Some simply believe in its ability to handle wide market fluctuations.  Many others do not have large amounts of money to invest, so investing smaller amounts over time is within their capabilities.  Still others are just more comfortable risking smaller amounts at a time rather than extending so much so soon.

Dollar cost averaging may not always be the best tactic for building savings, but it is tried-and-true and, more importantly, doable.  It must also be noted that the alternative features significantly larger risks that many people are not willing to take.  This is why dollar cost averaging has persevered through good times and bad.

Comments

  1. GL:

    So how does one actually earn money from dollar cost averaging?

    Reply

    • Safeer Mohiuddin Safeer Mohiuddin:

      Dollar cost averaging is a concept so that you can better invest your money depending on your needs. Its not something that you can take individually and try to make money off of. Instead, its a principle that you can use when investing in order to make the right decision for you in how many shares to buy and at what point of time. It’s also an important concept that helps illustrate the value of long-term investing.

      Reply

  2. Salmaan Javed:

    GL, it helps protect you from the potential decrease of a share price, or as some would say, it cuts your losses. On the flipside, dollar cost averaging secures your gains on stock price increases.

    For example…
    If you bought some NFLX shares last year, sold half of them last month and earned 20% per share, you would walk away with some money. If NFLX’s price dropped 30% today, you would have only lost 30% on the remaining half of shares while you made a profit on the shares you sold last month.

    Hopefully this scenario helped?

    Reply

    • Salmaan Javed:

      Whereas, if you had not sold half of your shares last month, you would have lost 30% on your entire stake in NFLX.

      Reply

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