Category: Money Tips
Created on Friday, 02 July 2010 07:00
Written by Samuel Goh Nai De
Dollar cost averaging is a strategy of investing equal dollar amounts regularly over specific time periods in a particular investment product or portfolio.
By engaging in dollar cost averaging, more shares or units (unit trusts/mutual funds) are purchased when prices are low and fewer shares or units (unit trusts/mutual funds) are purchased when prices are high. The rationale is to lower the total average cost per share/unit of the investment, thereby providing the investor a lower overall cost for the shares/units purchased over time.
In other words, instead of engaging in a lump-sum investment, the investor achieves his investment goals by slowly buying smaller amounts over a longer period of time. This spreads the overall cost outlay over several years, hence providing protection against changes in market conditions.
One key component to maximize profits using this strategy is to buy in during a declining market (market correction), using a scaled formula to buy more as the price falls. Then, as the trend reverses and the market recovers, adopt the same scaled formula to sell. Using this strategy, one can profit from the relationship between the value of a commodity or stock.
Many successful investors have already practice this investment strategy without realising it. The act of crafting an investment plan using dollar cost averaging could potentially save many investors a lot of time, effort, and of course, money. In this article, you will discover the three steps to craft an investment plan using dollar cost averaging, look at specific examples of how it can lower an investor’s cost basis, and reduce your investment portfolio risk. Crafting Your Own Dollar Cost Averaging Investment Plan
In order to craft an effective dollar cost averaging plan, you must do three things:
1. Determine the amount of money that you can invest on a monthly basis. Ensure that you are financially capable of adhering to the amount consistently; otherwise the plan will not effective.
2. Select an investment product (stocks, mutual funds, ETFs, index funds etc) that you seek to invest and hold on a long term basis (Five to ten years).
3. Invest the amount of money into the investment product that you have chosen at regular intervals (weekly, monthly or quarterly). If your stockbroker or financial consultant offers it, set up an automatic withdrawal plan so the process becomes automated by itself.
With a shorter time horizon, the strategy behaves more like lump sum investing. Studies have shown the best time horizons when investing in the stock market in terms of balancing return and risk have been six or 12 months. An Example of a Dollar Cost Averaging Plan
Suppose you have $10,000 and you decide to invest in a common stock. The date is January 1, 2010. You have two options: you can invest the money as a lump sum now, or you can set up a dollar cost averaging investment plan and gradually increase your exposure into the stock. You opt for the latter and decide to invest $1,000 each quarter for three years.
A simple mathematical calculation will reveal that had you invest your $10,000 in January 2010, you would have purchased 5000 shares at $2.00 each. When the stock closed for the year in December of 2012 at $1.50, your holdings would only be worth $7,500! But had you dollar cost averaged into the stock over the past three years, you would have owned 5,600 shares; at the average closing price of $1.55. This gives your holdings a market value of $8,680. Although it is still a loss, the stock only needs to go up to $1.55 for you to break even, not $2.00, which would have been required without the dollar cost averaging.
To go a step further, you can only break even at $2.00 without dollar cost averaging. With dollar cost averaging, you would have turned a profit of $2,520 when the stock hit that price thanks to your lower cost basis. ($2 sell price - $1.55 average cost basis = $0.45 profit x 5,600 shares = $2,520 total profit) About the Author:
. Disclaimer: The views expressed in this article reflect the personal views of the writer. The information provided herein is general in nature and does not have regard to the specific investment objectives, financial situation or the particular needs of any person. Wisdom Capital LLP and its affiliates, directors, associates, connected parties, employees and/or representatives may own or have an interest in the securities covered in this article. This article shall not be construed as an offer or solicitation to buy, sell or subscribe for any investment product or the giving of advice thereof. Please seek advice from a financial adviser regarding the suitability of the investment product, taking into account the specific investment objectives, financial situation or particular needs of any person in receipt of the recommendation, before the person makes a commitment to purchase the investment product.