Dollar cost averaging is an investment strategy that can help lower investment risk by spreading out investment over time. While dollar cost averaging can be beneficial at times, it does not guarantee investment success because the value of the investment can continue to decline despite averaging down. Nevertheless, dollar cost averaging is a commonly used investment technique that is used both knowingly and unknowingly by participants in retirement plans, and is also used by financial management companies.

HOW TO DOLLAR COST AVERAGE:

To dollar cost average one essentially spreads out one’s investment in a particular financial instrument over time with a number of fixed or variable payments. For example, if one participates in a managed retirement plan such as an IRA or a 401K, monthly contributions may be made into various investment products as per agreement with one’s financial planner.

In such an instance the money is invested in pre-selected investment products regardless of their value. Since some product such as mutual funds or exchange treaded funds can and do fluctuate in value, ones investment will be distributed over a range of prices with each scheduled payment. Thus, in the case of a mutual fund, it will be purchased on a staggered basis over time, sometimes at higher prices and other times lower. After time, one accumulates value at an averaged price since the mutual fund is being bought at multiple prices.

To illustrate, suppose one has a life insurance policy that contributes a portion of the monthly premium into a mutual fund or group of mutual funds. If the monthly premium is $100.00 and 75% of the premium is applied to 3 mutual funds, then every month $25 dollars will be applied to the purchasing of those mutual funds by the mutual fund manager and/or life insurance policy. If the prices of each of the funds are $12.50, $25.00 and $32 respectively at the time of the first premium application then the $75 will purchase 2 shares of the first fund, 1 share of the second and .78 of the third. If in the second month, the prices of the mutual funds change to $11.25, $27, and $30 then the next installment will purchase 2.22 of the first fund, .93 of the second and .83 of the third.

ADVANTAGE OF DOLLAR COST AVERAGING:

There are several advantages to using dollar cost averaging as an investment strategy. These advantages can be particularly useful over long periods of time is the investment product is well managed and performs well over time. Some of the advantages of dollar cost averaging are listed as follows:

*Evens out price risk
*Allows the potential to purchase more value for the dollar
*Facilitates more regular and manageable cash flow
*Can be a beneficial strategy for long-term investments

DISADVANTAGES OF DOLLAR COST AVERAGING:

Despite the clear advantages of dollar cost averaging it is generally not a perfect or flawless investment strategy in and of itself. For this reason it can be wise to consider the disadvantages as well as the advantages when thinking about using this strategy. Some of the disadvantages of dollar cost averaging are noted below:

*May not add value in the case of a bad investment
*Has the potential to lower value of ownership if investment product consistently rises in value
*Can increase risk if only one investment product is invested in
*Benefits may not be realized if not used in tandem with other investment strategies

Dollar cost averaging is an investment strategy that has been in practice for a significant time. It is based on the mathematical principle of averaging, and can be applied to a number of different investment products and is consequently a flexible investment strategy. Dollar cost averaging has several potential advantages that may contribute to lowering risk and expanding investment success over the long run. However, if a short run investment strategy is used and/or investment product prices do not decline then the cost of investment will rise more than had the full investment amount been applied at the beginning of the price rise. In other words, there are also disadvantages to using the dollar cost averaging method.

by A.W. Berry