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Smart Investing with Dollar Cost Averaging

Jun 13, 2008
Dollar Cost Averaging, or DCA, is a technique where you purchase a fixed dollar amount of your favorite investment at regular intervals, such as once per month.

When prices are down, you will receive more shares. When prices are higher, you will receive fewer shares. The idea is that you will be able to take advantage of dips in the prices but also minimize buying at higher prices. In the long run your average share price will be somewhere between the highs and lows throughout that time period, resulting in less volatility than putting all your money into just one or two large trades.

This technique is very simple and can be set to run automatically on many online brokerages such as ShareBuilder. This is a great option for investors who do not have time to sit at a computer every day watching for the perfect price to come along.

Example
Let's say two traders have $10,000 to buy Microsoft shares.

Trader A decides to put half of his money in right now at $28 per share, for 187 shares, and half of his money next month at $30 per share, for 166 shares.
Overall, he purchased 353 shares at an average price of $28.94.

Trader B decides to use DCA over a 4-month period, which is $2,500 per month. He receives 89 shares at $28, 83 shares at $30, 96 shares at $26, and 92 shares at $27.
Overall he purchased 360 shares at an average price of $26.67.

In this case, Trader B came out on top, purchasing 2% more shares at nearly 8% less than Trader A. That won't happen in every case, but you get the idea.

Why it Works
Since the markets have historically gone up over the long run, buying shares at regular intervals over the long run should go up too. DCA should reduce the effect of volatility in the prices throughout the year, but it will probably reduce your chances of large gains. This is the classic tradeoff in investing of risk versus reward.

Further Diversification
Any single stock has the potential to "bomb" on you, causing massive losses. One great way to reduce this risk greatly is to trade mutual funds, which often spread out your money over hundreds of different stocks. Combined with DCA, you should have a relatively safe and easy investment strategy.

Disclaimer
This technique is not guaranteed to make you profits or eliminate the risk of losing money. It is really just a way to average out share prices. For example, if a stock is dropping in price every month, your average price will be lower and lower, resulting in a loss overall.
About the Author
Nicholas Swezey is the creator of the free Stock Market Game at HowTheMarketWorks.com.
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