Chapter 3: Dollar Cost Averaging

Chapter 3: Dollar Cost Averaging

It's no secret that a strong gut is a prerequisite for investing in the stock market. Market indicators frequently move 10 percent in either direction. And most of us seldom have a giant bankroll to throw into the market at any given time.

So What's an Investor to Do?
One way to smooth out the market's swells and to take advantage of the "pay yourself first" rule is to dollar cost average.

Simply put, dollar cost averaging is investing the same amount of money on a regular basis--once a week, twice a month, monthly or quarterly -- in a stock or a mutual fund, regardless of the share price of that stock or mutual fund.

Why Would You Do That?
For a couple of reasons. First, a regular investment program is a good way to build wealth. Many of us only have a few dollars, or a few hundred dollars, to invest every month. For example, investing $150 per month means you're putting $1,800 to work for you annually.

Second, investing takes discipline -- particularly staying with the market when it's falling. A program of investing monthly, despite the market's direction, is a way to stick with the market during downturns.

How Does It Work?
Let's say you invest $100 in a no-load mutual fund every month. The net asset value of one share of the fund might be $25 one month, $20 the next, and $26 the third month. That means you bought four shares the first month, five shares the second month, and 3.85 shares the third month. During that three month period you acquired 13.85 shares at an average cost of $21.66--even though the share's net asset value was higher than that in two of those three months. With the share value at $26, you have made over $60 on your $300 investment.

The beauty of dollar cost averaging? When shares are lower, you buy more. When shares are higher, you buy fewer.

It works similarly when you invest in a specific stock. The only down side is that you have to pay broker's commissions when you do. That can drag your return down, unless you invest in a company's Dividend Reinvestment Program, or DRIP.

Dollar cost averaging makes the best sense when you put your money to work regularly -- with an automatic withdrawal from your paycheck or checking account.