Dolar Cost Averaging

Dollar cost averaging is buying a specific amount of an investment over time at specified intervals.  The idea behind dollar cost averaging is you will be buy more  shares/units when prices are low and less shares/units when prices are high.   Thus overtime this stragegy should give you an overall lower average cost per share than a stragey of purchasing a lump sum all at once.  Some investors choose to utilize dollar cost averaging by reinvesting their dividends when they receive them on their equity holdings.  If for example they own an equity that pays a dividend quarterly then they would reinvest those dividends each quarter in additional shares.  This will help grow their position in the company overtime ideally increasing their dividend which will inturn purchase more shares.  By the time the investor is ready to retire they will have a much larger quartelry dividend payment becuase they will own more shares/units.

There are both proponents and critics of this investing strategy.  One famous propenent is Suzy Ormanwho has said that dollar cost averaging reduces the investors exposure to certian forms of financial risk associated with making one large lump sum purchase.  Critics of this strategy include Timothy Middleton have said that dollar cost averaging is a marketing gimmick and not an solid stragegy to use.  Middleton has argued that this is a method of coaxing nervous investors to slowly put more money at risk then they would originally be willing to.  One thing for investors to look out for when considering dollar cost averaging is the fees.  This strategy will not work in a excessive fee environment.  If you can enroll in a dividend reinvestment plan for free though it is certainly something to consider.

An example of Dollar Cost Averaging

Lets say that an investor has decided to purchase a mutual fund and has decided to invest $500 per quarter.

Quarter      Unit Price       Units Purchased

1                     $13.53                     36.95

2                    $15.76                     31.73

3                    $10.99                     45.50

4                    $17.33                      28.85

Total Units Purchased 143.03

Average Unit Price $13.98

So as you can see from this example you are purchasing more units when the unit price is low and less when the unit price it high.  Your average unit price over the 12 month period for your purchases is $13.98.

Some investors who choose to believe the critics of dollar cost averaging unfortunately confuse dollar cost averaging with regular automatic investing.  Some investors choose to cut off their automatic retirement investing believing that dollar cost averaging will be doing them a disservice.  The key point is though most investors do not have the lump sum amount to invest all at once so regular automatic retirement investing is important no matter the market condition.