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Dollar Cost Averaging

Dollar Cost Averaging Example:

100-dollar-bills-screensaver-gifWhat if you have $16,000 you want to invest in a mutual fund. The date is December 1, 2009. You have two options: you can invest the money as a lump sum now, walk away and forget about it, or you can set up a dollar cost averaging plan and ease your way into the fund. You opt for the latter and decide to invest $4,000 each quarter for one year.  So, you start with the first $4,000 on Dec 1, 2009 when the S&P 500 mutual fund is below 1,100. Then, on March 1, 2010, the fund is still below 1,100 and you buy in at another low point.  Next, on June 1, 2010 the fund is around 1,050 when you put in your third $4,000.   Then the last $4,000 goes into the fund 3 months later on September 1, 2010 and the fund is again around 1,050, giving you more shares than in the first two purchases. Essentially, all of your purchases were between the purple lines below. Conversely, if you had put all the $1,600 into the fund in December 1, 2009, you ould have purchased the shares at a higher price than you would have purchased them had you used Dollar Cost Averaging.



  What is Dollar Cost Averaging?

Dollar cost averaging (also known as DCA) is an investment strategy that may be used with any type of investment. It works by investing equal amounts regularly and periodically over specific time periods, like $100 very month, in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.  Instead of investing assets in a lump sum, the investor works thier way into a position by slowly buying smaller amounts over a longer period of time. This spreads the cost basis out over several years, providing insulation against changes in market price.  

Dollar Cost Averaging and Long Term Investing:

Long term investing done via Dollar Cost Averaging is beneficial to investors because it can lead to positive gains in the stock market with very little risk.  This happens because investing for the long term in the stock market can result in an average annual gain of 12% over the long term. This is based on the fact that the S&P 500 has returned an average annual return of 12 % since 1926. With this kind of return an investor can expect their investment to double every six years. This is concluded by using the rule of 72; divide any return into 72 and you get the number of years it take to double an investment. Hence, 72 divided by 12 equals: 6. Therefore, it’s easy to see that long term investing is something that every investor should do.  This can be done easily with dollar cost averaging.

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