Dollar Cost Averaging

Dollar Cost Averaging is an investment strategy that is as simple as it gets allowing investing to be as painless as possible. It requires investing the same amount of money on a regular basis (once a month, once a week, once a quarter). By investing the same amount of money on a regular basis in the same stock or units of a mutual fund, you actually reduce the risk of investing! How? By receiving more shares when the market is down, and fewer shares when the market is up. This lowers the overall cost of the investment. This is a handy investment strategy for those funds or stocks that fluctuates in value. If you're not convinced, read the scenario below:

Scenario: Let's say you can see four months into the future. Let's also assume that you have the choice of two different stock funds in which to invest $100 a month.
Fund A: Goes from $10 a unit in the first month to $12.50 in the second month (a 25% gain!) to $20 in the third month. By the fourth month, it will be worth $25, for a total return of 250%!
Fund B: This fund will have a rougher time. It will also start at $10 a unit. During the first month, it will drop to $5 (a 50% loss!). It will drop even further in the second month, to $2 a unit, before crawling back to $10 in the final month.

Given the results, which fund are you most likely to invest your $100 a month? Exactly! Fund A! I mean, really, who doesn't want an investment to go up 250%?

Surprise! You don't... at least not for many, many years. Why? Because you still have to invest! What good does it do to have your total $400 investment grow so much? All it means is that you now have to pay 250% more for the same investment you started four months ago. This means you are getting less investment for each dollar. In our example, here are the actual results of the four month investment scenario:

At the end of the four month period, the final value of your investment is determined by multiplying the current number of units by the current unit price. In this case, the investment in Fund A is worth $675 (25 units x $25/unit), which is pretty good. However, an investment in Fund B is worth $900! (90 units x $10/unit)!

The reason Fund B earned so much money is that you kept buying units during the low-cost second and third months. Your average share price was only $4.44! By contrast, Fund A had an average share price of $14.81, since your automatic purchase plan continued to buy shares, even when the price rose. And remember, at this point the papers would all be telling you how lousy Fund B is with its 0% return in the last four months compared to the amazing 250% return of Fund A.

- Information quoted from "The Investment Book", by Kevin Cork