What Is Dollar Cost Averaging?

By Markets Fool.com

While there's pretty much no such thing as a risk-free investment, there are strategies you can employ to minimize your risk. One such tactic is known as dollar-cost averaging. With dollar-cost averaging, you commit to buying a fixed dollar amount of a specific investment, like a stock or mutual fund, at regular intervals, regardless of the share price at the time of purchase. With this approach, you wind up buying more shares when prices are low and fewer shares when prices are high.

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How it works

Also known as a constant dollar plan, dollar-cost averaging is a less risky way to sink money into a particular investment. With dollar-cost averaging, rather than invest a lump sum up front, you're coming up with a preset schedule where you'll invest a certain amount of money at specific intervals over time. But while the amount of money you put in at each interval will be the same, the number of shares that money buys you will not. That's because market fluctuations dictate share prices, causing them to rise and fall.

When the market is up, stock prices go up, and so your money will buy you fewer shares. On the flipside, when the market is down, stock prices fall, and so you're able to get more shares for your money.

Benefits of dollar-cost averaging

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Dollar cost averaging can be a smart way to invest because it mitigates certain risks inherent in investing. For the most part, you can't predict when the market will go up or down. By buying a fixed dollar amount of a certain investment on a regular schedule, what you're essentially doing is working on accumulating assets rather than spinning your wheels trying to perfectly time the market.

Let's say you want to invest $20,000 in Company X, whose stock is currently trading for $20 a share. Invest that $20,000 in a single lump sum, and you're locking yourself into that particular price. But what happens if Company X's stock falls to $10 a share two weeks later? Suddenly, you have all of your money tied up in a single stock, and you'd lose half of your investment if you were liquidate that position.

On the other hand, if you were to take that $20,000 and invest it evenly over the course of 10 months, you'd instead commit to purchasing however many shares of Company X's stock $2,000 can buy you each month. Now if Company X's stock is doing well, or if the market is doing well, that could mean paying $20 a share. It could also mean paying $10 a share. There's no way to know, but the logic is that if you stick to your strategy, you'll probably end up overpaying for shares at some point and underpaying at another, and over time, it will work out in your favor.

A long-term strategy

Dollar cost averaging can be a smart investment strategy, but it only works if you're thinking somewhat long-term. Because the market can have lengthy upturns and downswings, dollar-cost averaging doesn't offer the same degree of protection if you're looking to get in and get out within just a few months' time. But if you're willing to be in it for the long haul, dollar-cost averaging can spare you the inevitable aggravation that comes with attempting -- and failing -- to time the market just right.

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