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Dollar-Cost Averaging

This article was written by in Investing. 5 comments.


Is dollar-cost averaging (DCA) a sound investing strategy?

In theory, dollar-cost averaging allows you to invest smaller portions of your money over a longer period of time, reducing the chance that you pay a price too high for any individual investment. If your ideal allocation calls for $50,000 to be invested in the stock market through an index fund like VTSMX, rather than buying $50,000 worth of the fund in one day in a lump sum, dollar-cost averaging spreads that purchase in equal amounts out over days, weeks, months, or even years to reduce your exposure to daily fluctuations of the market. By investing the same dollar amount each time, you buy more shares when the price is lower and fewer shares when the price is higher.

In other words, if you buy $50,000 of VTSMX on January 1 and the stock market crashes on January 2 without recovering for six months, you might kick yourself for not having the cash available to buy when the price of the fund was more favorable in the months your investment on January 1.

Many brokers allow you to dollar-cost average or invest in a lump sum. Here are a few current special offers.

The only good reason for dollar-cost averaging is you may not have that $50,000 ready at one time. If you rely on investing only from money left over from your paycheck every two weeks, you don’t have a lump sum available. Those who do have funds available might have already missed out by not investing earlier.

Investing in the stock market as soon as possible with whatever money you have available, in order to form your ideal asset allocation, beats dollar-cost averaging in the long run. Dollar-cost averaging would leave your ideal allocation unfulfilled by leaving a larger percentage of your total assets in cash, uninvested.

Overall, the stock market trends upward, even at the company level if that company is healthy. If you buy individual stocks of a healthy company, the price should move in an upward trend over the long term. Dollar-cost averaging will never be able to make up lost ground compared to investing an available lump sum because you will, on average, dollar-cost average your way into higher prices.

While there may be exceptions when looking at your investment performance in the short term, especially in an environment where stocks are stagnant or declining, but as a long term investing strategy, dollar-cost averaging fails. Small instances of luck will eventually give way to major trends. So far, almost every experiment I’ve personally attempted has shown that I cannot reliably time the market as well as I want to. I almost always would have done better by just investing as soon as possible rather than sitting with cash.

Psychologically, however, dollar-cost average has a more important role. Spreading out the short-term exposure to any specific day’s stock price can make an investment in the stock market feel less risky. If you’d otherwise be concerned about your investments that might fall 1%, 5%, 10%, or more in one day, dollar-cost averaging can help allay those fears. If you have those fears, you may want to reassess whether you’re comfortable with the risk of the stock market in the first place.

Here are some links for thought:

Please share your dollar-cost averaging experiences, concerns, and thoughts.

Updated March 24, 2011 and originally published June 16, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 5 comments… read them below or add one }

avatar Rob Bennett

Those who practice Dollar-Cost Averaging are ignoring price when they buy stocks. I wrote a column this week arguing that “Dollar-Cost Averaging Is a Loser Strategy”:

http://deathby1000papercuts.com/2010/06/investi…

Rob

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avatar Doug Warshauer

There is truth to your argument that dollar cost averaging when you have a large lump sum to invest will, on average, generate a lower return than simply investing it all on day one. More often than not, you will pay higher prices for your later investments than you did for your initial one.

If you were to have many opportunities to invest a large lump sum, it would clearly make sense to take advantage of the odds in your favor and, each time, invest the entire sum at once. For instance, if you owned a business that through off $50,000 of excess income each month, you would not dollar cost average each $50,000 chunk. Of course, another way to look at it would be that you are actually dollar cost averaging your $600,000 annual income!

For someone who only gets one chance at investing $50,000 into equities, the calculation is a little different. While dollar cost averaging lowers the expected return, it also lowers the risk. If you dollar cost average your investment in over a year, the expected return diminishes by about $1,500 ($25,000 x 6% excess equity return over cash). I think many people would think this a reasonable price to pay to avoid a precipitous drop in their entire investment within a year after they make it, if investing this money is a once in a lifetime opportunity.

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avatar Doug Warshauer

There is truth to your argument that dollar cost averaging when you have a large lump sum to invest will, on average, generate a lower return than simply investing it all on day one. More often than not, you will pay higher prices for your later investments than you did for your initial one.

If you were to have many opportunities to invest a large lump sum, it would clearly make sense to take advantage of the odds in your favor and, each time, invest the entire sum at once. For instance, if you owned a business that through off $50,000 of excess income each month, you would not dollar cost average each $50,000 chunk. Of course, another way to look at it would be that you are actually dollar cost averaging your $600,000 annual income!

For someone who only gets one chance at investing $50,000 into equities, the calculation is a little different. While dollar cost averaging lowers the expected return, it also lowers the risk. If you dollar cost average your investment in over a year, the expected return diminishes by about $1,500 ($25,000 x 6% excess equity return over cash). I think many people would think this a reasonable price to pay to avoid a precipitous drop in their entire investment within a year after they make it, if investing this money is a once in a lifetime opportunity.

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avatar UH2L

One thing you’re forgetting is that most people dollar cost average as they earn money, (as in investing in their 401K’s every two weeks when they get paid). Effectively, they’re investing in small periodic lump sums. For people with a bunch of cash, then there is a decision to be made and I still think dollar cost averaging makes more sense. That’s because volatility is very high (at least these days). The market goes up or down 2% quite often. If you balance this against yearly returns of 3% or 5% or maybe 7%, the day you buy with a lump sum can make a huge difference. I would only buy with the lump sum if I feel lucky.

With volat

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avatar Rob Drury

Dollar cost averaging is just that; paying an average cost for an investment over time. A previous poster claimed that one would DCA himself into higher prices because of the general upward trend of the market. He is overlooking the fact that the purchase price of an investment is irrelevant; it is the relative movement of the price of that investment after purchase that is important. In other words, the probability of a short term loss is virtually equal to that of a short term gain (hence, an average). Because of this, the only thing on which the investor misses out is the opportunity cost of not having the entire available amount invested from the start, which could either either gain or lose during those intervals. The resulting reduction in risk far outweighs the increased earning potential of immediately exposing a lump sum. Very little long-term potential is lost, but tremendous safety is gained. Combine the DCA strategy with regular rebalancing, and one has a recipe for success that is as close to risk-free as the market can offer, without missing any significant growth potential. Any other way is simply gambling.

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