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Dollar Cost Averaging in Today's Market

written by: Trent Lorcher•edited by: Jean Scheid•updated: 2/2/2010

The most common investment strategy is the HAP method--hope and pray. Other popular methods include wing it, social security, eat cat food when I get old, and Enron stock options. I prefer dollar cost averaging.

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    A Quick Quiz

    Investor A invests $100 on the 5th of each month:

    • On October 5, he bought stock XYZ at $5 per share.
    • On November 5, XYZ stock was $ 5.5 per share.
    • On December 5, XYZ stock was $ 6 per share.
    • On January 5, XYZ stock was $6.5 per share
    • On February 5, XYZ stock was $7 per share.

    Investor B invests $100 on the 5th of each month:

    • On October 5, she bought ABC stock at $5 per share
    • On November 5, ABC stock was $ 4per share.
    • On December 5, ABC stock was $ 3 per share.
    • On January 5, ABC stock was $4 per share
    • On February 5, ABC stock was $5 per share.

    Would you rather be Investor B or Investor A?

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    A Solid Long Term Investment Strategy

    Before giving the correct answer, I will explain what dollar cost averaging is: Investing a fixed amount of money on a regular schedule, regardless of stock price.

    Most Americans implement dollar cost averaging in today's market without knowing it. Most investors put a preset amount in their 401 (k)s, Roth IRAs, College Savings Plans, and other long term savings accounts on a specific day each month. It is an effective way to use the market's volatility to amass wealth (but what about my shrinking 401 (k) account? More on that in a second).

    Let's take a look at how dollar cost averaging in today's market works.

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    Investor A or Investor B?

    Most people choose Investor A. Most people are wrong. On February 5, Investor A has accumulated $591.64 in XYZ stock. Investor B has accumulated $616.67 in ABC stock.

    How is that possible?

    Because XYZ stock was rising in price, Investor A paid more per share. While ABC was sinking in value, Investor B was able to buy more shares of it: Investor A owns approximately 64.5 shares of XYZ at $7 per share. Investor B owns 123.3 shares of ABC at $5 per share.

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    Pros and Cons

    As already mentioned, dollar cost averaging is a wise long term investment strategy and is ideal for the following:

    1. retirement or savings accounts for those who have at least 10 years until retirement - If investor B, for example, needed her money when ABC stock was $3 per share, she would have lost a great deal of money.
    2. diversified savings programs - Individual stocks often plummet and never recover--Enron, GM, Citi. The broad stock market always recovers.
    3. a fluctuating market - Market fluctuations should be embraced by the long term investor. That's how investors make money.
    4. investors with discipline - Disciplined investors don't get caught up in emotions. When the market's on the rise, people get greedy and buy. When the market sinks, investors get scared and sell. Undisciplined investors buy high and sell low.

    It is not a guarantee if the stockholder is forced to sell in a steadily declining market. Numerous investors became motivated sellers at the wrong time--2008, 2001, 1974, 1928. Those who are retiring soon or are currently retired should have a very small percentage in stocks and a large percentage in fixed income vehicles.