The recent economic turmoil experienced in the US and around the world has frightened many investors out of the market. With the US stock market losing roughly 50% of its value in a relatively short period of time, many investors have completely sold off their holdings looking to preserve whatever they had left. However, even in times like these the prudent investor can still benefit when the market is down.

How you ask? Dollar Cost Averaging. OK, so just what is dollar cost averaging? Simply put, it is an investment strategy whereby you invest a fixed amount in regular intervals rather than in a lump sum. It can be weekly, bi-weekly, monthly, whatever. The investment vehicle is usually fixed as well and can take the form of stocks, index funds or mutual funds. In fact, many people take advantage of dollar cost averaging without even knowing. If you contribute periodically to a mutual fund for example, you are already dollar cost averaging!

Timing the Market

If you have ever invested, you no doubt have heard that you should buy low and sell high. That’s good advice. You have also heard that you should buy and hold you investments over the long term. That’s also good advice. It’s good advice because the stock market has, historically, risen over any 10 year period in its history. If you buy a stock and hold it for 10 years or more, you are just about guaranteed to realize a profit.

Timing the market is trying to predict when a particular investment will rise or fall in value and buying or selling at those points. Market timing is extremely difficult and possibly the worst investment strategy of all. Though many may claim some 'secret' or 'propriety' system for timing the market, to date there has been no proven method developed to do so. If such a method did exist, day traders and short-term traders would be retiring as billionaires by droves!

Enter Dollar Cost Averaging

The idea behind dollar cost averaging is to invest new money without having to time the market to find the best entry point. As you will be investing at different times in the market you will be able to buy investments at different prices and reduce your overall cost and maximize your profit potential. If you invest a set amount monthly in a particular stock, you will buy more units when the price falls and fewer when the price rises. This feature of dollar cost averaging helps act as a buffer for market fluctuations. Sure, the value of your investments falls when the stock falls but you also bought more shares of it when it was lower. Then when the share value rises you have more shares with which to profit.

So how does this work practically? Let’s look at an example. You have $1200 to invest. You decide to buy XYZ stock which is trading at $13.55 per share. You have 2 choices. Invest all $1200 in a lump sum purchase or invest in increments. say $100 per month for 12 months. If you chose to invest in a lump sum you would have purchased 88.56 shares at the original price of $13.55. After twelve months the value of your investment would be $1,244.28 for a profit of $44.28.

If the market fluctuates as is usually the case and you elected to invest incrementally, you would have purchased 100.04 shares and the ending value would be $1,405.50 for a profit of $205.50. See the table below. In this scenario, dollar cost averaging outperformed a lump sum investment to a total of $161.22.

Monthly      Share   # Shares Bought    Account Value
Investment   Price

  $100       $13.55      7.38              $100.00
  $100       $12.20      8.20              $190.04
  $100       $11.35      8.81              $276.80
  $100       $10.90      9.17              $365.82
  $100       $10.00     10.00              $435.62
  $100       $10.75      9.30              $568.29
  $100       $11.85      8.58              $715.87
  $100       $11.95      8.37              $834.30
  $100       $12.50      8.00              $972.70
  $100       $12.95      7.72             $1107.73
  $100       $13.55      7.38             $1259.04
  $100       $14.05      7.12             $1405.50
--------------------------------------------------
 $1200                 100.04             $1405.50  Totals

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In a falling market where the investment values fall month to month both lump sum and dollar cost averaging strategies would yield a loss. A lump sum investment of $1,200 would have bought you 83.62 shares, if you were buying at an original price of $14.35. The value of your investment after a year would be $836.24 or a loss of $363.76.

If you elected to invest incrementally $100 per month, your ending value would be $1014.59 for a loss of only $185.41. Again, dollar cost averaging would outperform a lump sum investment to the tune of $178.35 less in losses. See the table below:

Monthly      Share   # Shares Bought    Account Value
Investment   Price

  $100       $14.85      6.97              $100.00
  $100       $13.80      7.25              $196.17
  $100       $13.45      7.43              $291.19
  $100       $12.85      7.78              $378.20
  $100       $12.45      8.03              $466.43
  $100       $12.10      8.26              $553.32
  $100       $11.75      8.51              $637.31
  $100       $11.35      8.81              $715.62
  $100       $10.90      9.17              $787.24
  $100       $10.55      9.48              $861.97
  $100       $10.25      9.76              $937.45
  $100       $10.00     10.00             $1014.59
--------------------------------------------------
 $1200                 101.46             $1014.59  Totals

One scenario where a lump sum investment will outperform dollar cost averaging is in a rising market where the value of the investment rises from month to month. A lump sum investment of $1,200.00 would purchase 120.00 shares, if you bought XYZ at an original price of, say $10.00. After twelve months your investment would be worth $1,758.00.

If you had invested $100.00 a month over the same 12 months, you would have bought only 98.13 shares of XYZ and the ending value would be $1,437.56. In this case a lump sum investment would outperform dollar cost averaging to the tune of $320.44. But honestly, how often do you see an investment increase in value for 12 consecutive months! Typically, the market fluctuates from day to day, week to week and month to month. Fluctuation in markets is what makes dollar cost averaging work and a wise choice as an investment strategy.

In Closing

There is a reason almost all financial experts do not recommend attempting to time the market. It is almost impossible to do and usually beyond the abilities of the average investor. Even if we could time the market, the average investor doesn’t have the time or resources to be successful. We need an investment strategy that allows us to reap the benefits of rising and fluctuating markets and that also tempers our losses when markets fall. Dollar cost averaging accomplishes both these goals and is about as close to an investment autopilot as you will find. Still, the wise investor will monitor his investments and make adjustments as required.

So, when you plan your next investment consider the benefits that dollar cost averaging may have for you.