Dollar Cost Averaging 101 - All About this Investment Strategy

Dollar Cost Averaging (DCA) is a relatively conservative investing strategy that reduces risk by spreading out purchases of a stock or fund over time. With a DCA strategy, you commit a fixed amount of funds on a regular schedule to purchase a specific investment, regardless of the share price. When the price is high, you are buying fewer shares; when the price is low, you are buying more shares.

This strategy keeps you from placing a larger lump-sum investment in the market at just the wrong time. In essence, this is the same type of investment as contributing a set monthly amount of money to your 401(k).

Does this investment strategy work? DCA may work for you if you have a lower risk tolerance, but it is important to understand the conditions under which it will provide the best results. DCA is intended to be a relatively long-term strategy with low maintenance. You are not trying to time the market constantly. However, you should "time" the market once — when you embark on your initial strategy.

As you choose your stocks or funds for a DCA strategy, it is important to make sure that they are reasonably valued when you begin. The consequences are not as severe as if you had invested a large lump sum at a price peak, but it will still take a long time to recover since you cannot cut your losses through selling shares. Check price-to-earnings ratio trends and other company information to make sure the stocks are a sound long-term investment.

Notice the plural "stocks." Using this strategy without diversification aggravates the very risk factors that it was designed to mitigate. Make sure that you keep the proper stock diversification to fit your risk profile when you embark on your DCA strategy.

For those who like the concept of DCA but find it too restrictive, there are variations on the theme that incorporate short-term trends. Two major variations change the monthly amount of invested by a factor that you choose and allow you to hedge in one direction based on your preferences.

Value DCA – Invest more money after a month with negative returns, and less after months with good returns. In this case, you are looking to pick up your stocks at bargain values and are assuming that the stocks will rebound. You are invoking half of the old adage "buy low, sell high." This philosophy can backfire as you have no means to sell a continually bad stock and you will not get the full benefit of a prolonged bull run in your stocks.

Momentum DCA – The opposite of Value DCA, where you invest more in a positive market and less in a negative market. As the name implies, you assume momentum will continue in the short term. The downside is that you can miss bargain valuations of your stock or end up with a greatly overvalued holding.

In a relentless bull market like this one, a simple lump sum investment would have outperformed all the DCA options. However, consider your time horizon and whether you are buying into an overvalued market. When the market valuations are high and your time horizon is intermediate but not extremely long, a DCA strategy can be more effective.

Which philosophy works best for you? That depends on your goals and your risk tolerance. If you are an aggressive investor with plenty of risk tolerance and a goal of maximizing returns, this strategy is probably not for you. If you have lower risk tolerance and are more interested in security than in optimization, DCA is likely to be your strategic choice.

If you do choose DCA, do not forget the basic rules — diversification is still important, and selecting the proper investments is critical. DCA, or any strategy, will fail if you choose poorly performing and/or overvalued stocks for your investments.