average averaging concepts cost costs diversification dollar efficiency essential_concepts finance finanical frugality introduction invest investing investing, investment investmentadvice investments money stocks strategy trading wikiofnote

My tags:

From Wikipedia, the free encyclopedia

Dollar cost averaging is the practice of investing a fixed dollar amount at regular intervals (such as monthly) in a particular investment or portfolio, regardless of its share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high. Dollar cost averaging is also called DCA and constant dollar plan in the US, pound-cost averaging in the UK, and by the currency-neutral term cost average effect^[1].

Some financial advisors such as Suze Orman ^[2] claim that DCA reduces exposure to risk associated with making a single large purchase.

Contents 1 Parameters 2 Return 3 Criticism 4 Variations 5 References

[edit] Parameters

In dollar cost averaging, the investor decides on three parameters: the fixed amount of money invested each time, and investment frequency, and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sum investing. One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.^[3]

[edit] Return

Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested is^[4]

where p_F is the final price of the investment and is the harmonic mean of the purchase prices. If the time between purchases is small compared to the investment period, then can be estimated by the harmonic mean of all the prices within the purchase period.

[edit] Criticism

DCA has been widely criticized by other advisors (such as Dave Ramsey^[5]), economists, and academic finance researchers as more of a marketing gimmick than a sound investment strategy^[6]. They say that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.^[7] Analysis supporting dollar cost averaging has been criticized because it often ignores transaction fees,^{[dubious – discuss]} which can be substantial. Numerous studies of real market performance, models, and theoretical analysis of the strategy have shown that in addition to having the admitted lower overall returns, DCA does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy. ^[8]

[edit] Variations

There are several variations of dollar cost averaging. For example, one variation is to decide whether or not to dollar cost average based on the market’s P/E ratio.^[9]

[edit] References

1. ^ "Durchschnittskosteneffekt". http://de.wikipedia.org/wiki/Durchschnittskosteneffekt. Retrieved on 2009-01-12. 
2. ^ http://www.suzeorman.com/dt/calc_dollarcostaverage1.cfm
3. ^ Jones, Bill. "Do Not Dollar-Cost-Average for More than Twelve Months". http://www.efficientfrontier.com/ef/997/dca.htm. Retrieved on 2009-01-05. 
4. ^ "Derivation of the dollar cost averaging return formula". http://tsp.peacefulgains.com/Derivation-of-the-dollar-cost-averaging-return-formula/. Retrieved on 2009-01-05. 
5. ^ "Ask Dave: Dollar-Cost Averaging?". http://www.daveramsey.com/etc/askdave/index.cfm?intContentItemId=6251. Retrieved on 2009-02-13. 
6. ^ Middleton, Timothy (2005-01-04). "The costly myth of dollar-cost averaging". http://moneycentral.msn.com/content/P104966.asp. Retrieved on 2009-01-05. 
7. ^ "Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk". http://beginnersinvest.about.com/cs/newinvestors/a/041901a.htm. Retrieved on 2009-03-22. 
8. ^ Knight, John R.; Lewis Mandell (10 April 2002). "Nobody gains from dollar cost averaging analytical, numerical and empirical results". Financial Services Review (Elsevier Science Inc.) 2 (1). http://www.sciencedirect.com/science/article/B6W4D-45JK782-6/2/bec35bbe850cf520ddbb20d9eb634271. 
9. ^ "Dollar Cost Averaging". http://www.sigmainvesting.com/advanced-investing-topics/dollar-cost-averaging. Retrieved on 2009-01-05. 

• The Intelligent Investor: revised 1972 edition Benjamin Graham, Jason Zweig. Collins, 2003. ISBN 0-06-055566-1
• Investopedia