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What is Dollar Cost Averaging and Why Should You Use it?

What is dollar cost averaging? Also called the constant dollar plan, it is the technique of investing a fixed amount of money consistently. When purchasing stocks, this allows more shares to be purchased when prices are lower, and less shares when prices are higher.

dollar cost averaging

For example, let’s say you established dollar cost averaging of $400 a month into a manufacturing company. At $25 a share, you’d be able to buy 16 shares the first month. If the price dropped in the second month to $20 a share, you would purchase 20 shares… and so on.

If you can understand that investments rise and fall in value constantly, you can become better prepared to deal with the fluctuations. When dollar cost averaging, you look at a loss in value as a greater buying opportunity, instead of immediately writing off the experience as a loss.

Assuming the price of the investment does eventually rise, a dollar cost averaging plan will help you capitalize on lower market swings by assigning you more shares. It also helps you stay consistent as an investor, which will materialize into superior gains in the long term.

Even if the price of the investment doesn’t rise to the point that you originally planned, dollar cost averaging still helped you save consistently. While you might’ve lost some value in your investment, which can happen with any investment, you can still sell out and reallocate your funds to a better opportunity.

Because of this chance of loss, you want to make sure you are pairing a solid dollar cost averaging plan with diversification. This is a fantastic way to maximize your investment gains.

The benefits of dollar cost averaging are clearly advantageous to most investors. Best of all, this strategy helps you automatically buy low and sell high.

You’ll buy more shares when stock prices are lower, and buy less when stock prices are higher. Over the long term, a system like this will help you both stay invested in the market and profit from its natural bear and bull market cycles.

Combine Value Investing with DCA

Many greats have made a living from value investing. They have been documented in their abilities to beat the market. You probably have heard of the most famous value investor Warren Buffett. There’s also others such as Buffett’s mentor Benjamin Graham, John Templeton and Seth Klarman.

These greats had the patience to wait for the market to adjust to their liking and the wisdom to know which opportunities were worth investing in. Obviously, this is easier said than done.

The secret behind their success is really no secret at all. Basically, the concept of value investing boils down to understanding what a company’s intrinsic value is… and buying that company’s stock when it is trading at a discount to that intrinsic value.

This is a concept termed “margin of safety”. When you buy a company with a margin of safety, this means you are buying it at less than its intrinsic value. Let’s say the company closed shop tomorrow and sold off all of its assets and paid its liabilities. With its cash in the books, would the company have any value?

If the answer to that question is yes, then you’ve found a typical value investment. These are the kinds of stocks that the legends look for.

A company that is priced at less than its liquidation value gives the investor a margin of safety, because in the worst case if the business shuts down tomorrow the stockholder still owns a cash value in the company’s excess liquidation proceeds. Any additional margin between the price paid and this balance creates the margin of safety and provides the investor with a hefty profit.

Wheras most of Wall Street believes that a stock must have higher risk to give higher returns, the value investor uses the concept of margin of safety to state that a stock with lower risk actually has the best chance at higher returns.

What you’ll generally see on Wall Street is that most companies never get to the liquidation stage. More often than not, a company will be temporarily hated on the street and thus trading at a discount, but will eventually recover as time goes by.

This happens over and over again, until the enterprising value investor is able to compound his wealth nicely by finding many of these situations.

Combining a potent strategy like value investing to another effective investment strategy like dollar cost averaging and diversification can reap rewards for yourself for many years to come.

Don’t be the person who can’t recognize true value when they see it.

Take advantage of this new knowledge. If you want to learn more about value investing, and get tips that have been passed down from the investing greats like Warren Buffett and Benjamin Graham, subscribe to my free list.