Dollar-cost averaging is a time-tested method of smoothing out the roller-coaster ride that awaits those who try to time the stock market. You don't have to be brilliant to make it work, and you don't even have to pay especially close attention to what's happening in the stock market or in the economy. With dollar-cost averaging, you simply invest a fixed amount regularly, depending on your saving schedule. The trick is to keep to your schedule, regardless of whether stock prices go up or down.
Because you're investing a fixed amount at fixed intervals, your dollars buy more shares when prices are low than they do when prices are high. As a result, the average purchase price of your stock will be lower than the average of the market prices over the same time.
For example, say you invest $300 a month over a six-month period in SureThing Enterprises, a stock that ranges in price from a low of $20 to a high of $30. Here's a look at what dollar-cost averaging would do. (This example ignores brokerage commissions)
First month: The stock is trading at $30 a share. Your $300 investment buys then shares of SureThing.
Second month: The market has taken a tumble and the price of your stock has fallen to $25. You buy 12 shares.
Third month: Things have stabilized. The price of your stocks is still $25, and you buy another 12 shares.
Fourth month: On news of a takeover bid by another company, the price soars to $33. You buy 9 shares.
Fifth month: The takeover bid falls through and the price dips back down to $25. You pick up another 12 shares.
Sixth month: An earnings report that falls short of analysts' expectations causes a couple mutual funds to bail out of your stock, pushing the price down to $20 a share. You acquire 15 shares.
Let's add it up: So far you've spent, in round numbers, $1,800 and you own 70 shares, which means you paid an average of $25.71 a share. Compare that with other ways you could have acquired the stock: If you had bought ten shares during each of those six months, you'd own 60 shares at an average price per share of $26.33. If you had invested the entire $1,800 at the start of the period, you'd own 60 shares at $30 per share. You can begin to see the advantages of dollar-cost averaging. The only reliable way to beat it over the long haul is to buy consistently at the bottom and sell the stock at the top - not a very realistic expectation
Now you might have noticed that at the end of the sixth month you were holding stock for which you had paid an average price of nearly $26 in a market that was willing to pay you only $20 a share. Should you sell and cut your losses? Not necessarily. Now is a good time to reassess your faith in SureThing; carefully reexamine the fundamentals. If fundamentals still justify your faith, this dip in the price represents a good opportunity to buy more shares.
Dollar-cost averaging won't automatically improve the performance of your portfolio. But don't underestimate the value of the added discipline, organization and peace of mind it gives you. It's natural to be frightened away from owning stocks when prices head down, even though experience has shown that such times can be the best time to buy.
If you have a lump sum to invest, such as a pension payout or an inheritance, you can take advantage of dollar-cost averaging by parking the sum in a money-market fund and taking some of it out in regular installments to buy stocks.
