Dollar cost averaging is a technique used by investors to invest a large sum of money in parts over a period of time. Let's say you have $10,000 and you want to invest in a mutual fund or in a stock. You have two options -

1. You invest the entire amount at one go
2. You invest the entire amount over 1 or 2 years

The second style of investing is called dollar cost averaging.

Why is dollar cost averaging useful and how does it help investor?

The answer lies in the inherent nature of Mr. Market. The market is very erratic. Stock prices fluctuate a lot. Because of fluctuation in the stock price an investor can't be sure that she is buying at the lowest price. The price may become higher or lower in future.

Using dollar cost averaging technique an investor buys stocks over a period of time with different prices - sometime lower, sometime higher than the previous prices. Because of this the overall cost of owning stocks averages out over the price range paid to purchase stocks. It will be clear with the following example.

Let's say Mary wants to buy 100 stocks of a company "A" and she buys them all in one go. Let's assume that the price of each stock is $10. So Mary spends $1000 to buy 100 stocks of company "A".

Now let's say Mary decided that she doesn't want to buy 100 stocks in one go. She decides that she wants to buy 10 stocks every month over 10 months. Since stock prices fluctuate let's assume that stocks of "A" cost Mary as follows:

1st Month's price $10 - cost of 10 shares = $100
2nd Month's price $10.05 - cost of 10 shares = $100.5
3rd Month's price $9.6 - cost of 10 shares = $96
4th Month's price $9.8 - cost of 10 shares = $98
5th month's price $10.1 - cost of 10 shares = $101
6th month's price $9.75 - cost of 10 shares = $97.5
7th month's price $9.56 - cost of 10 shares = $95.6
8th month's price $10.2 - cost of 10 shares = $102
9th month's price $10.15 - cost of 10 shares = $101.5
10th month's price $9.76 - cost of 10 shares = $97.6
---------------------------------------
Total cost of 100 Shares = $989.7

So she bought total 100 shares for 989.7 over a period of 10 months and that saved her $10.3 but still she has same number of shares (100). Her cost basis also reduced with average cost per share becoming $9.89 compared to $10 she would have paid had she bought all the stocks in one go.

Imagine how big the savings can be with much larger fluctuation in stock price and longer period of averaging.

Through dollar cost averaging (investing small amounts over a period of time) Mary could reduce her average cost. You might argue that the technique isn't advantageous when the stock price keep rising. But bear in mind that no stock keeps rising forever and that's why this technique is good for long term investors.

Following the strategy of dollar cost averaging is not good when you are buying stocks from broker (such as Etrade, Scottrade) and you use small amount of money to buy stocks. The fees and broker's commission will become a real drag on your return. Imagine paying $7 in fee for every $100 you invest for dollar cost averaging. That's 7%! If you put more than $5K every time for dollar cost averaging then it's fine.

Because of fee overhead dollar cost averaging works great for small investor in mutual fund. Most of the mutual funds have automatic investment plan through which you can invest amount as small as $50 per month regularly without worrying a bit about fee.

I really like dollar cost averaging through mutual funds as I don't have large sum every month to invest. I believe in consistent investing and regular investing.

Also for you to do dollar cost averaging you might have to open the mutual fund account directly with the fund company. If you buy mutual fund through broker you will face the same issue of broker charging you fee for every transaction you make through her.