INVESTING TOOLS - DOLLAR-COST AVERAGING

DOLLAR-COST AVERAGING
What Is This Tool?
Dollar-cost averaging is an investment strategy that attempts to spread out investment risk over time. It does so by requiring small and
periodic set dollar amount purchases of an asset over a lengthy period. It is often recommended for small investors who have little investment monies at their disposal or who are unable or unwilling to follow investment markets regularly.
How Is It Computed?
Investors seeking to use this strategy must figure out how much they can afford to contribute systematically to a dollar-cost averaging account each month and/or quarter.
Where Is It Found?
The biggest promoters of dollar-cost averaging have been mutual funds, whose typically small investment minimums allow investors to implement
this strategy easily in a cost-effective way. Many funds and brokerages make
this process easy by allowing automatic purchases through direct deductions from
investors’ checking accounts or paychecks.
Investors may unknowingly be using this strategy as part of employer-sponsored
savings plans such as 401(k) retirement programs. Many of these benefit plans routinely make equal purchases of assets at set periods, quietly accomplishing dollarcost averaging.
How Is It Used for Investment Decisions?
Dollar-cost averaging attempts toeliminate one investment decision: timing.
By distributing purchases over a lengthy period, an investor lowers the risk of
purchasing a large amount of an investment at the highest possible price. By using a
set dollar amount, when prices are high, this strategy tells an investor to buy fewer
shares. (See Figure )
When prices are low, the investor would accumulate more discounted shares.
Therefore, the strategy screens out whims that could result in the investor buying high and selling low.
Dollar-cost averaging will work as long as prices of the assets targeted by the
strategy rise over the long haul.
A Word of Caution:
Dollar-cost averaging can result in high transaction costs
that can lower returns over time. That is why mutual funds, which often charge either
no sales fee or a flat commission, are a popular way to implement this strategy.
Such plans can also create a nightmare at tax time after the investment is sold.
Each of the systematic purchases should be separately accounted for on the tax
return.