The basic concept is relatively simple. Essentially, you invest a fixed amount of money in shares of the same stock at regular intervals – usually, on a monthly basis – regardless of the stock’s performance. (The same principle can be applied to investments in mutual funds.) And you continue to invest the same way for an extended period of time.
As a result, you may be able to acquire shares of the stock at a lower cost per share than the prevailing price, providing some volatility protection. This strategy removes the guesswork of trying to “time” the market.
For example, let’s say you decide to invest $100 monthly in Technology Inc. stock. If the stock sells at $20 a share in the first month, you’ll receive five shares. Now assume that the price of the stock drops to $10 a share, so you acquire ten shares in the second month. In the third month, the price of the stock rebounds to $25 a share, giving you four shares.
After three months, you’ve acquired 19 shares of Technology Inc. stock for $300. Your “average cost per share” is $15.79 ($300 divided by 19). But the stock’s average price per share during the same time was $18.33 ($20 + $10 + $25 divided by 3). This averaging effect makes the per-share cost of your investment lower than the average market price per share for the same time period.
On the other hand, there’s no guarantee that dollar cost averaging will work. It doesn’t eliminate the risk of a loss in a declining market or that the average cost per share will move slowly. In fact, if you choose a stock that continues to slide downward, your paper losses could pile up.
Dollar cost averaging requires dedication. Advocates say you must stick with this approach in both good times and bad. That means you can’t stop investing if the market goes into a tailspin. Yet there may come a time when you figure you have to cut your losses.
Dollar-cost averaging is a disciplined investment strategy, but it doesn’t eliminate the need to review your investments periodically to make sure that they still meet your expectations and your risk tolerance.