Investing? Get your feet wet

Another strategy designed to combat the unknown elements of the stock market is called “dollar-cost averaging,” or DCA. Dollar-Cost Averaging (DCA) can provide a good means of getting your feet wet in the market without the potential of jumping in headfirst. The tenet of DCA is simple: By investing systematically over a large period of time, you will normally see that you have a lower average cost per share, which can help increase your overall return. Because no one knows from one day to the next what the market is going to do, investing over several months rather than in one lump sum amount may be a better idea for those investors who are a little more squeamish about investing, or who have a lower risk tolerance. Employing DCA also means that you may wind up purchasing shares at their 52-week high, but you may also buy shares at their all-time low.

Over time, the cost of the shares averages out so that you are neither paying top dollar, nor are you paying bargain basement prices. But employing the DCA method doesn’t guarantee a profit, nor will it insure you against a loss. Dollar-cost averaging is generally used for mutual finds, but may also be used within the sub accounts of annuities. Let’s assume that you want to invest a total of $50,000 in the XYZ Growth Fund but you don’t want to do it all at one time. Rather, you wish to spread out your investment because you don’t know what the market is going to do. Therefore, you decide you want to invest $5,000 per month for the next 10 months to make up your entire investment. By doing this, you will be purchasing shares at, presumably, 10 different prices, which could lower your average price per share, and thus, increase your potential for making a profit from this fund.

Above illustrates the advantage of dollar-cost averaging. By investing the same amount of money over a period of time, the investor will realise a different number of shares purchased each time at a different price. However, over time the investor’s average cost per share decreases. There is also a difference between the average cost per share and the average market price, which adds to the investor’s benefit. These figures are for illustration purposes only and aren’t meant to indicate any type of investment performance. Dollar-cost averaging doesn’t assure a profit against losses in a declining market. Investors should consider their ability to continue investing through periods of low market prices. Looking at the above illustration, which demonstrates a hypothetical situation, as the price per share fluctuates over time, the investor is able to purchase shares at a variety of different prices, which then equal his average price per share. Notice that the hypothetical purchase prices run the gamut over the time frame. This strategy helps decrease the volatility of investing in a single security by investing over time, instead of in a lump sum.

For investors who wish to invest in a lump sum, they need to be aware that they may wind up putting their money in at the height of the market, or they may be lucky enough to get in when the market is at a bottom point. This is not to say that one way is better than the other. That choice is up to individual investors and their levels of risk tolerance. If you, the investor, believe that the market will be going back up at the time you are ready to invest, then a lump sum investment may be best. However, if you are unsure about which way the market will go, then perhaps using DCA is the best idea. Essentially, DCA is best for investors who have the cash flow to invest a set amount at regular intervals and aren’t prone to try and decide whether the market is going to go up or go down. This strategy also works best for those who like to invest and hold a position for a longer amount of time. Either way, the worst situation is to not be invested at all. (Continued next week)