Dollar Cost Averaging

I’ll bet you’re familiar with this concept.  Dollar cost averaging calls for the purchase of a specific dollar amount of an investment on a periodic time schedule.  Actually, that sounds a little complex.  Here’s an example to better illustrate…

Say you have $100k to invest in a managed investment (it could be a hedge fund, mutual fund, etc.  To employ dollar cost averaging, you need to pick a specific dollar amount of the investment and plan to purchase that amount at predetermined time intervals.  In this case, let’s say you decide that you will buy $20k of the investment every two months until you’re fully invested.  Thus, when your entry plan is complete you will have purchased $100k of the investment over a 10 month period of time. 

What’s the “averaging” part of the equation?  The value of any “unit” of a managed investment (be it shares, units, etc.) will change on a month-to-month basis (or perhaps even day-to-day).  Since you made five separate purchases, you can assume that each purchase transaction will have been done at a different price.  By taking all five of the purchase prices into consideration, you arrive at an “average” price at which you entered the entire $100k investment.

Dollar cost averaging can yield benefits.  If the value of the managed investment declines over the 10 month period, you’ll be able to “ease” into the investment gradually and overall, you may secure a lower “average” entry price (lower than if you had simply invested the $100k in one transaction). 

On the flip side of the coin however, using dollar cost averaging can also be a disadvantage.  This is true when the value of the managed investment increases steadily over the 10-month entry period. In that case, each of your purchases will be made at higher prices.