Financial Literacy

Periodically, you will probably want to make changes to your investment portfolio. Once you've decided to make a change, the temptation is to do it all at once.

You may want to be a little more cautious, however, and dollar-cost–average into it. The strategy of systematically investing a fixed dollar amount over time is called dollar-cost averaging. You will benefit by minimizing the risk of buying high and selling low.

For example, you are dollar-cost–averaging when you invest a fixed dollar amount each month into your 401(k) plan. Automatic monthly withdrawals from your checking account to purchase stock or mutual funds accomplishes the same thing.

Let's look at how buying an investment by dollar-cost–averaging can benefit you. Say you're earning $40,000 and you decide to save 6% of your annual income—that's $200 per month.

Example

The average price of the shares over the six month period is ($10 + $8 + $5 + $5 + $8 + $12.50) ÷ 6 = $8.08. But since you invested a fixed sum of money each month, your average cost per share is $7.23 ($1,200 divided by 166 shares). When you dollar-cost–average, you buy relatively more shares when the price is lower.

Shifting your assets gradually is also a good way to get out of an investment, particularly when you may have a lot of money in company stock. As you need to diversify, consider selling your stock off gradually, and not all at once.

But isn't it better to wait until the stock is at a high point? That's called market timing. Even the savviest people on Wall Street find it difficult to time the market. A logical way to invest may be by dollar-cost–averaging.

Dollar-cost averaging cannot guarantee a profit or protect against a loss, and you should consider your financial ability to continue purchases through periods of low price levels.