The market always has, and always will go up and down. Often it happens for seemingly no reason at all. For those who have come into a large sum of money, they do not want to make the mistake of investing it all at once, and getting in at a market peak. The investment risk (that is the risk of losing money on an investment) associated can be troublesome. Instead, putting in a little bit over a period of time a person can dollar cost average their way into the market.
Example of Dollar Cost Averaging
John inherits $120,000 from his grandparents. It is paid to him in a lump sum. He wants to invest the money into a balanced mutual fund, but does not want to put it all in only to have it immediately lose value. Instead he will put it into the money market, and once per month, for the next year, he will have $10,000 transferred into the fund of his choosing. This way if he is at a market peak this month, he will only put 1/12 of his money in at the high. Consider the following values per share of the fund John uses:
January 1: $8.50
February 1: $9.00
March 1: $11.00
April 1: $10.00
May 1: $9.00
June 1: $8.00
July 1: $7.50
August 1: $7.00
September 1: $8.00
October 1: $7.50
November 1: $6.50
December 1: $7.00
If John were to put all $120,000 in on January 1st, he would buy 14,117 shares. By December those shares would be worth $98,823 (not including any dividends he may have received). On the other hand, if he had put in $10,000 per month, he would have bought some shares at a higher price, and some shares at a lower price. By the time December came, John would have 14,867 shares that were worth $104,076. By spreading out the time period in which he invested John was able to gain 750 shares and make his investment worth over $5,000 more than if he dumped all the money in at once.
Investing is important, and it is important to know that most investments are going to last much longer than one year. When sudden windfalls occur, the best thing a person can do is to slowly start putting that money into the market. That way they can minimize their exposure to overpriced funds, and maximize their exposure when those funds are underpriced. Doing so will result in a portfolio that not only has less volatility, but also shows greater gains.
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