Dollar-Cost Averaging-How to Get Higher Returns Without Taking Significant Risks

imagesThe formula for investment success seems simple enough: “Buy low and sell high.” The problem, of course, is predicting when a security’s price will be low and when it will be high. The best analysts and market watchers are fortunate indeed if they can predict the general direction of the market correctly. Certainly, the individual investor cannot be expected to properly “time” specific securities purchases and sales with consistent success.

Dollar Cost Averaging is a method that helps to maximize the opportunity to buy low. To be more specific, Dollar-Cost-Averaging enables you to buy, over time, shares of a security at an average cost which is less than the average price. More importantly, it greatly reduces the risk that you’ll invest all or the majority of your assets at or near a market high.

It may sound too good to be true, but Dollar-Cost-Averaging really can work. All it requires is a commitment on your part to invest a fixed amount of money into the investment of your choice at regular intervals. The result is that you’ll buy more shares when the price is low and fewer shares when the price is high. The example below illustrates this concept:

The investor commits $1,000 to a certain stock each month. The lowest share price was $25 (in April), a price at which 40 shares could be purchased for the $1,000. The highest share price was $50 (in February and June), at which only 20 shares could be purchased with the $1,000. Over the course of six months 155 shares were purchased for $6,000.

Dollar-Cost-Averaging

Month Purchased

Investment Amount

Share Price

Shares Purchased

January

$1,000

$40

25

February

$1,000

$50

20

March

$1,000

$40

25

April

$1,000

$25

40

May

$1,000

$40

25

June

$1,000

$50

20

Totals

$6,000

155

Average Share Price = Your Average Cost Per Share = Difference/Savings Per share= =

$40.83 $38.70 $2.13

The figures shown are for illustrative purposes only and don’t reflect any actual performance of any particular investment.

silver-dollar-cost-averagingDividing $6,000 by 155 we arrive at our average cost per share: $38.70. The average price (the sum of the six share prices divided by six) over this period was $40.83, or $2.13 higher than we paid for each share on average. This confirms the principle of Dollar‐Cost‐Averaging. Most significant, however, is the fact that Dollar‐Cost‐Averaging kept us from investing the entire $6,000 at $50 per share. Had we invested the entire lump sum at that price we would have purchased just 120 shares—35 less than purchased using Dollar‐ Cost‐Averaging! Of course, we could have been extremely lucky and invested all our money at $25 per share—the low—in which case we would have purchased 240 shares.

If you have an aggressive risk temperament and are comfortable trying to time the market in pursuit of maximum gains, then Dollar‐Cost‐Averaging may not be for you. Conversely, if you’re looking for absolute guarantees, this time‐tested strategy won’t assure a profit. Remember, Dollar‐Cost‐Averaging works towards reducing your average cost per share. You’ll enjoy a profit only if your selling price exceeds your average cost per share (as it does in the example illustrated here).

Dollar‐Cost‐Averaging works best for the investor who is neither an aggressive market timer nor the other extreme ‐‐ the risk‐averse investor. In other words, Dollar‐Cost‐Averaging is for the moderate investor who is willing to give up some of a security’s upside potential in exchange for some downside protection.

This is because Dollar‐Cost‐Averaging doesn’t assure a profit or protect you from loss in a declining market. Also, since such a program involves regular investment purchases regardless of fluctuating price levels of the investment, consider your financial ability to continue purchases through periods of low price levels.

One of the most convenient and flexible means of beginning a Dollar‐Cost‐Averaging program is by setting up an automatic investment program. Most plans and investment product providers welcome and encourage automatic bank drafts, with a minimum investment as low as $25. Don’t miss out on the valuable benefits of Dollar‐Cost‐Averaging.

Guest Post by Zach MacDougall who runs a comprehensive financial planning practice out of San Diego, CA. He specializes in working with medical professionals and small business owners.

This information is a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

Securian Financial Group, Inc.

www.securian.com
400 Robert Street North, St. Paul, MN 55101-2098 © 2010 Securian Financial Group, Inc. All rights reserved.

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