Monday, May 26, 2008

Stock Market Strategy - Dollar Cost Averaging

Is dollar cost averaging a suitable stock market investing strategy for beginners?

In this article I will describe what dollar cost averaging is and how beginner investors can put it to good use. From my recollection, Benjamin Graham (the father of value investing) proposed that the use of "formulas" like this was a good way to protect investors from themselves by reducing the risk of investors trying to time the market.

What Is Dollar Cost Averaging?

As I've already said, dollar cost averaging is a stock market investment strategy (or a form of formula investing). The basic idea is that an investor buys stocks at regular intervals thereby 'averaging' their purchase price. The advantage of this method is that investors avoid putting all of their their money into the stock market right at the top or just before a fall. By buying stocks in smaller amounts on a regular basis, you will be buying right through the stock market cycle - both the ups and downs.

Is Dollar Cost Averaging For You?

I have to admit to being a little cynical when it comes to dollar cost averaging. Sometimes it seems to be more of a marketing gimmick employed by mutual funds and other purveyors of investment products. They seem to use it to promote products whereby you buy shares or units in their mutual fund on a monthly basis. And you can understand why - they put a lot of effort into convincing you to part with your money, so rather than getting you to buy once they get you onto a regular plan. They will even take the money out of your pay to make it easier.

However, I think there are some scenarios where dollar cost averaging may be worthy of consideration.

I think the principle of regular investment is sound. It can help prevent a new investor putting all of their money in at the top of the market. Also, in uncertain and volatile times (such as we're experiencing at the moment) it can help prevent investor procrastination. By that I mean an investor who sits on his (or her) hands waiting for the market to bottom out only to wait too long and miss the start of the recovery. Or they might try to pick the bottom and invest once they see a recovery under way, only to find the recovery short lived and the subsequent downturn takes the market to new lows.

In this situation, a regular investment program can help the investor psychologically. By committing a portion of their capital this month, then another portion the following month, they can cover both cases. If the market does recover, they can take solace in the fact that they bought in at lower prices. And if the market continues its downward trend they still have the funds available to make purchases at lower levels.

Another potential positive of dollar cost averaging as a stock market investing strategy is in its use as a regular savings plan. In my opinion a regular savings plan is a great idea regardless of what shape or form it takes. If by drip feed investing a portion of your pay or salary into a financial market you are able to accumulate and growth your wealth then I'm all for it.

In the past, I've used a form of dollar cost averaging at times of market uncertainty - including the most recent downturn. Rather than trying to indulge in market timing by picking the bottom of the market, I would buy the stock which provided the greatest value at the time I was buying. With financial markets plummeting, I was concerned about the risk of investing all of my money only to see the market drop by another 10% or more. Regardless of how objective I try to be, the idea of purchasing stock, even for the long term, only to see it keep falling is an unpleasant one. But by keeping funds in reserve, I'm able to purchase that or other stocks at the lower prices. Please note that this is where I'm confident of the long term prospects of the company in which I'm buying stock.

So, as you can see that even though I have my concerns about dollar cost averaging, there are times when it may be useful. But as with the application of any stock market strategy, it should revolve around the purchase of quality stocks.

1 comment:


This is excellent advice. I cannot stress more the value of dollar cost averaging its so very important for investors to realize.