Dollar Cost Averaging

Dollar cost averaging, also known as the constant dollar plan, is one technique used to reduce market risk. How dollar cost averaging works is actually pretty simple -- the investor shields himself or herself from the effects of changes in market price by spending a fixed amount on an investment each month, regardless of the price of the share that month. This way, more shares can be purchased when share prices are low, and lesser shares purchased when the prices are high.

Anyone planning on using dollar cost averaging as an investment technique usually goes through a series of three steps. First, you must decide on how much money to spend on your investment every month. This must be an amount thatyou know you can pay on a monthly basis, since failure to do so will make the plan less effective than it needs to be. A good way to ensure that you make your payment as agreed each month is to set up an automatic withdrawal system from your account directly into your investment account. The second step involves selecting an investment plan, and the last involves the regular payment into the security that you have chosen, either manually or through the automated withdrawal system.

Despite the advantage that dollar cost averaging brings, there are also negatives to DCA that potential investors need to be aware of. For one, analysis of DCA does not include transaction fees, which can be substantial. Studies have also shown that dollar cost averaging results to lower overall returns compared to other investment techniques.