Dollar Cost Averaging
Dollar cost averaging is a long-term investing strategy designed to minimize the effects of market fluctuations. The investor contributes the same amount of money to an investment account on a dedicated schedule - quarterly, monthly, weekly, daily, etc. For example, contributing $100 on the 15th of each month is dollar cost averaging.
The dollar cost averaging investment strategy assumes that the market will go up and down over time – but the overall trend over the years and decades will be rising market values. If you contribute the same amount of money every month, you'll be investing during down months and during up months. As long as the market continues to follow its life-long history of overall upward movement, the dollar cost averaging investor should see overall gains But because the market does experience down times, this strategy works best when an investor uses it for many years or decades.
Making dollar cost averaging work for you
The theory says the more often a person can invest, the more he/she will benefit from dollar cost averaging - so a weekly $100 investment is preferable to a yearly $5,200 investment even though the same amount of money is involved.
But for most investors it isn't practical to contribute the same amount to an investment on a weekly basis - instead most people participate in dollar cost averaging on a semimonthly, monthly or quarterly basis. You could be using dollar cost averaging without even realizing it: most employer-sponsored retirement plans take payroll deductions monthly, semimonthly or every two weeks. And the same amount of money comes out with each payroll deduction.
Based on market history, the result of dollar cost averaging should be that more shares are purchased when prices dip lower and fewer shares are purchased when prices spike higher. Over an extended period of time, the average cost paid per share should be lower than the average share price. See the chart below for an example.