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What is Dollar Cost Averaging?
Added: (Thu May 29 2008)
Dollar cost averaging is a technique to reduce the risk of losing money when stocks suddenly slump after purchase. For instance, suppose you bought $1,000 worth of shares last week; this week the bottom dropped out of the market and now your shares are only worth $250 - or less. Had you employed the technique of dollar cost averaging, you would have bought only say, $100 dollars worth of shares per week, so you would either be able to buy those crashed shares at a reduced rate, or you would change your mind and buy something else. You would not have seen your whole investment sum lose value so dramatically.
While in theory, dollar cost averaging seems like - and indeed is - good protection, market research shows that losing money in this way is not common. And in fact, when the investment is intended for the long term, the benefits of dollar cost averaging are outweighed by the better performance of returns for those who did not use it.
It does however have its uses for short-term investments where the risk is higher. Research tells us that when the price to earning ratio (P/E) is high, dollar cost averaging is more likely to be of benefit to the investor.
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