Dollar-cost averaging: an investment strategy for uncertain times

Timothy Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.

Over the last decade, stock investors have seen both the best and the worst that the market can offer. Many have learned that trying to time the ups and downs of the market and individual stocks is nearly impossible.

While there are many investment strategies that you can use to help manage your portfolio through fluctuations in the market, dollar-cost averaging can be one of the most effective. When you use dollar-cost averaging, you purchase the same dollar amount of shares at regular intervals, regardless of the price of the shares. Here's an example of how the strategy works.

Say you choose to invest $100 a month in XYZ company stock. Every month, regardless of the price of XYZ stock, you purchase $100 worth.

Let's say that in January, shares of XYZ cost $5 per share. So, using the money set aside, you would acquire 20 shares. In February, the cost for the same investment decreases to $2.50 per share, so you would be able to purchase 40 shares that month with your $100. In March and April, the shares are selling at $4 per share, so you can buy 25 shares at the end of these months. In May, you again are able to obtain $20 shares at $5, while in June the stock closes at $10, enabling you to buy 10 shares. As a result, over the six-month period, you spent $600 to buy a total of 140 shares of XYZ.

Looking back, if you had invested the same $600 as a lump sum in January, you would have acquired only 120 shares of XYZ ($600 divided by the January per-share cost of $5 equals 120).

Through dollar cost averaging, however, not only are you able to acquire 20 additional shares, but the average price you paid per share declined from $5 to about $4.29. (Keep in mind that this example is for illustrative purposes. Additional costs involved with investing were not include in the example, and it does not reflect the performance of any specific investment.)

In hindsight, you might be thinking that you would have been better off investing the lump sum in February instead of June. However, we all know we can't predict the market, and while the past few years have shown declines in the market, the next few years may be full of increasing stock valuations.

Dollar-cost averaging is designed to help you buy more shares when the price is low and fewer shares when the price is high, with an overall goal of lowering your cost per share. As you can see, by investing a predetermined amount of money every month, or even on a quarterly basis, you don't have to be as concerned about the actual price of the investment and whether its value is about to rise or fall.

Dollar-cost averaging can help make you a disciplined investor by requiring you to commit to investing a regular fixed amount of money. This will help you remember to make those investments and spare you the anguish of having to come up with a larger amount of money all at once. And if you choose to invest on the same day each month, you will take the guesswork out of trying to time the market.

Keep in mind, this investment strategy doesn't guarantee profit or protect against loss in declining markets, and it is most effective when you take a long-term approach to investing. Because dollar-cost averaging requires continuous investment in securities regardless of fluctuating prices, you should consider your financial ability to continue purchases through periods of low price levels. Talk with your financial consultant about strategies that may work best for your goals and needs.