The Pros and Cons of Dollar-Cost Averaging
Having balanced your budget and analyzed your risk, you're now ready to start tackling that "investing" entry on your list of new year's resolutions. But where do you start? When should you buy? How can you get the best return on your investment?
If you've never heard of dollar-cost averaging, you have now and if you're wondering how it all works, then you've come to the right place.
Dollar-cost averaging (DCA) is a relatively simple concept: invest fixed dollar amounts on a monthly basis regardless of price and theorectically, you'll come out with more shares for your investment.
Let's say that you've allocated $500 per month to invest. Keeping in mind that the market goes up and down all the time, that $500 will buy less shares when the price is high and more shares when the price is low. Remember, using the DCA strategy, you'll invest that $500 regardless of what the price is so you don't have to keep up with all the daily fluctuations of the stock market - your investing plan will automatically do that for you. At the end of a year, you will have purchased more shares at the lower price and fewer shares at higher prices. In theory.
I say "in theory" because no one can predict what the stock market will do. If its on a steady decline, then shares you purchased at the beginning of the year would obviously be worth less than your original investment amount. If on the other hand, the market is rising, the majority of your purchases would be at much higher prices. Of course, that truth will play a role in your portfolio, regardless of how you choose to invest your money so this isn't really a downside that's exclusive to just DCA.
Additionally, many very notable names in the investing circle say that there is no real evidence that DCA gives you any greater return than you would get from investing a lump sum (although many "other" notable names think DCA is the greatest thing since sliced bread - wise bread that is :). But the truth is that ultimately, most expert analysts recommend investing your lump sum at all once for the best return.
But that's assuming that you have a lump sum to invest.
The real purpose of DCA is to allow investors to ease into a market they might not have otherwise been able to access. The average household doesn't always have an extra $10,000, $20,000 or $50,000 just lying around to be invested. Quite the contrary, most of us work with much smaller amounts, making it difficult to play the "buy low, sell high" game. DCA helps to level the playing field a little by allowing you to "buy low" over a period of time.
The second thing that DCA does is that it gives a wary investor an alternative to sinking their entire fortune into a questionable market. You may want to invest that lump sum but perhaps you have issues with where the market is going. DCA allows you to take baby steps until you find your investing comfort level.
Of course, there's no guarantee that dollar-cost averaging will bring you any better results than you would have gotten from any other strategy. But for the average working guy or gal, a DCA strategy in a few solid mutual funds or stocks certainly isn't a bad thing to try. And then later, after you've made your millions and you're looking for a place to dump that extra fifty grand, you can always try the lump sum method and then compare the two :)