It’s widely popular in the financial media to encourage the strategy of dollar-cost averaging (DCA) when investing. It’s a simple strategy that calls for investing the same dollar amount at regular intervals. When you assume that stocks or other investments at lower prices are bargains, dollar-cost averaging allows you to buy more of an investment when the price is better (lower), and less of an investment when the price is higher.
For example, consider someone who invests $100 into a broad index fund or ETF every month on the first day of the month. The price of the index, driven by the market, on January 1 is $10, so $100 buys ten shares. The price on February 1 is $12.50, so at this worse price, $100 buys only eight shares. You’ve received a better deal for a larger portion of your shares than you would have if you kept the number of shares you purchased steady rather than the dollar amount. In other words, if your other option was splitting the eighteen shares over two months, buying nine in January and nine in February, your gains would be lower.
This is, of course, a simplification of the issue. Many people often argue that, under the assumption that the stock market generally rises over long periods of time, you’d almost always be better off by buying the full eighteen shares as early as possible — in this case, January 1. Assuming the values trend upwards, that’s always the case — or at least it averages out to be over time. Many financial gurus then suggest forgetting about the idea of dollar-cost averaging and turn towards investing a lump-sum as soon as possible.
Reality gets in the way of that idea, unfortunately. Over my lifetime, I might invest $1 million. I have no idea of that will be true of course, because I cannot predict my future, but it’s a good figure to start with. Of course I’d be better off investing that $1 million at the moment I am legally allowed to do so, while just letting the account grow (on average) over large swaths of time. In fact, isn’t this the dream of every time-traveler? “If I could just take the $100 I have now, put it in the bank in 1795, and show up to collect the proceeds this year, I’d be a multi-millionaire!” Those who prefer gambling might be interested in taking Grays Sports Almanac: Complete Sports Statistics 1950-2000, a surprisingly thin compendium, back to 1955 and placing bets. (Come to think of it, Biff Tannen from the alternative 1985 reminds me a little of Donald Trump. Is it just me?)
Comparing lump-sum investing with dollar-cost averaging is not feasible most of the time. Thanks to reality, most of us are not time-travelers. We cannot take the amount we intend to invest over our life time and do it all at once at the beginning. You can, however, use leverage to invest more than you can afford to take advantage of these gains, but your returns will be hurt by the interest you pay on this debt and it amplifies your risk to often unacceptable levels. No, most people don’t invest using a lump sum because they need to earn the money they plan to invest through income, and that generally happens over time.
Furthermore, the more frequently buy an investment, the possibility for racking up transaction fees is higher, and these eat into your profits quickly. That’s a negative aspect of DCA, and it’s avoidable by dealing only with low-cost investments.
Dollar-cost averaging is effective because it allows people who can only budget for a small amount of investing to buy more shares of their investment when prices are lower. Most people can’t afford to invest in a lump sum.
Published or updated May 6, 2011.