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Smart Investor Tip of the Day
One of the most powerful and underused investment strategy that can be deployed is dollar cost averaging (DCA). This technique is designed to reduce market risk by making consistent security purchases at predetermined amounts over the course of a period.
Many investors like to make lump sum investment purchases but because market conditions are unpredictable it’s possible that making such a large one-time purchase can result in a lower return than if you were to work into a position by slowly buying small amounts over a long period of time. By persuing this latter course of action it spreads the cost and potential risk over many years, thus padding against market price fluctuations. In other words, it lowers the total average cost/share. This approach also has the benefit of giving one the chance to purchase shares when prices are low and take on fewer shares when they are high-priced.
Dollar Cost Averaging is primarily for long-term investors. And many discount brokers, such as Questrade, offer automatic withdrawal plans for such a strategy.
Index funds are the ideal types of securities for the dollar cost averaging plan because they help diversify your portfolio and keep the cost more stable as you execute your dollar cost approach.
This approach is not without its critics. Because you are only investing a small amount each month, for example, its going to take a long while before a descent amount of shares is held. Also DCA will likely increase transaction costs. Each time you invest a bit more into your portfolio there will be a fee by the discount broker to do so.
Interestingly, if the stock price continues to rise over the period then the DCA plan will result in a higher average stock price than say if you had invested in one lump sum.
When all is said and done the greatest benefit DCA brings is the sense of discipline. Because the investment amount is so small it makes it easier for people to save for the future.