The Pros and Cons of Dollar-Cost Averaging

by Kate Luther on 6 February 2008 9 comments
Photo: Stock.Xchng

Having balanced your budget and analyzed your risk, you're now ready to start tackling that "investing" entry on your list of new year's resolutions. But where do you start? When should you buy? How can you get the best return on your investment?

If you've never heard of dollar-cost averaging, you have now and if you're wondering how it all works, then you've come to the right place.

Dollar-cost averaging (DCA) is a relatively simple concept: invest fixed dollar amounts on a monthly basis regardless of price and theorectically, you'll come out with more shares for your investment.

How?

Let's say that you've allocated $500 per month to invest. Keeping in mind that the market goes up and down all the time, that $500 will buy less shares when the price is high and more shares when the price is low. Remember, using the DCA strategy, you'll invest that $500 regardless of what the price is so you don't have to keep up with all the daily fluctuations of the stock market - your investing plan will automatically do that for you. At the end of a year, you will have purchased more shares at the lower price and fewer shares at higher prices. In theory.

I say "in theory" because no one can predict what the stock market will do. If its on a steady decline, then shares you purchased at the beginning of the year would obviously be worth less than your original investment amount. If on the other hand, the market is rising, the majority of your purchases would be at much higher prices. Of course, that truth will play a role in your portfolio, regardless of how you choose to invest your money so this isn't really a downside that's exclusive to just DCA.

Additionally, many very notable names in the investing circle say that there is no real evidence that DCA gives you any greater return than you would get from investing a lump sum (although many "other" notable names think DCA is the greatest thing since sliced bread - wise bread that is :). But the truth is that ultimately, most expert analysts recommend investing your lump sum at all once for the best return.

But that's assuming that you have a lump sum to invest.

The real purpose of DCA is to allow investors to ease into a market they might not have otherwise been able to access. The average household doesn't always have an extra $10,000, $20,000 or $50,000 just lying around to be invested. Quite the contrary, most of us work with much smaller amounts, making it difficult to play the "buy low, sell high" game. DCA helps to level the playing field a little by allowing you to "buy low" over a period of time.

The second thing that DCA does is that it gives a wary investor an alternative to sinking their entire fortune into a questionable market. You may want to invest that lump sum but perhaps you have issues with where the market is going. DCA allows you to take baby steps until you find your investing comfort level.

Of course, there's no guarantee that dollar-cost averaging will bring you any better results than you would have gotten from any other strategy. But for the average working guy or gal, a DCA strategy in a few solid mutual funds or stocks certainly isn't a bad thing to try. And then later, after you've made your millions and you're looking for a place to dump that extra fifty grand, you can always try the lump sum method and then compare the two :)

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Guest's picture
jdp

Excellent post! Tackling that "investing" entry on my to-do list has just seemed to scary.

Guest's picture
IO

This is a well written post. I liked how well you addressed the pros and cons of the issue.

One thing I would like to add is that the purpose of DCA is two-fold. The first is to avoid 'timing the market'. This is a very daunting task and even the experts are really only marginally better at it than the roulette table. The second is to make investing approachable and regular. You can put as little as $50/month into most plans found out on the web. This can get people into the market on a small time basis so that they will see some benefit from it, however small it may be. DCA is a really great way to help the average person get into the market without resorting to pulling out hair while watching your stock take a tumble.
Imagine:
Situation 1) The stock is heading downhill. You just put $10k on it! Oh no! It's worth $9k now! You've JUST LOST $1000! What are you going to do? ARG!
Situation 2) The stock is heading downhill. You just put $100 on it. Oh well, it may only be worth $90 now, but you're buying $100 more next month. Then if your stock climbs back to the $100 mark, you're back at even on the first $100, and now your second $100 is worth $111! Yippie! You've gained $11! Thanks, dip in the market!

Guest's picture

Kate excellent review of DCA. I've read a few scientific analysis done on the merits of DCA versus lump sum investing, most studies I recall show little to no risk reduction or an increased rate-of-return – over the long haul. I think it is a personal comfort issue, especially in a volatile market like we are seeing now. Also, no one that I am aware of has a long track record of knowing when is the best time to get in the market – so I wouldn’t hold on to my lump sum for best time to get in. This can lead to the practice of trying to ‘time-the-market:’ getting in and out at the best of all possible times. Most investors do so at the wrong time, and end up with a lower ror.

Kate Luther's picture

I agree... DCA does offer some comfort to investors, especially during a volatile market. I also agree with IO that DCA eliminates the need to "time the market" which as everyone here as already noted, is almost impossible to do. There are some noteworthy analysts that question the real benefits of DCA but personally, I like it.

Glad everyone is enjoying this post :)

lghbob's picture
lghbob

Friendly reminder...

 

The market of '29 did not recover until 1954

 

Now... Just to save some time, here's the argument against this problem.

 

http://www.netgainrealestate.com/index.php?q=1929_can_it_happen_again

 

IMHO, the article which sounds believable, is not.  The very arguments and assumptions made in January, are already being challenged by the current market. 

 

 

 

my opinion only

Guest's picture
Kevin

The DCA vs. lump sum debates always seem a little silly to me because it's very rare to find someone who acquires a fortune overnight and needs to decide whether to buy immediately or use DCA. I guess if you won the lottery or inherited a fortune you'd have this dilemma. But most people are saving part of their monthly salary and so have a relatively small amount to invest every month. In this case lump sum isn't even an option; it comes down to DCA vs. making a market timing decision every month. A lot has been written about how DCA is the better of those two choices.

On balance, I do think the complex analyses supporting lump sum investments are valid, so if I ever do win the lottery or inherit a fortune I'll make a big lump sum buy.

Guest's picture
Kathryn

@Kevin

The circumstances where this decision comes into play are not that uncommon at all. It's applicable to anyone who gets an annual bonus they can chose to invest, a tax refund they don't need to use immediately to pay off debt, or a 401(k) rollover, for example.

Guest's picture
Kathryn

I'm not sure that invest-as-you-go is truly the same thing as DCA, which to me implies intentionally NOT investing money you have to invest RIGHT NOW but rather spreading the investment of a given sum over time as a way to (theoretically) reduce risk. If you invest your savings as soon as they accumulate, you're still doing lump sum investing--it's just smaller lumps.

Husband and I talked this through last year w/r/t our IRAs, and I thought it through came to the conclusion that over the long run on average you'll do better with lump sum than with DCA. I then discovered that the weight of expert opinion and historical data was on my side.

"I don't need to be right all the time. I can't help it that I just AM."

Guest's picture
Andys2i

In my opinion, and owing to current market conditions, dollar cost averaging or buying shares as they fall away because they seem "cheap", is not smart investing for the simple reason that most investors do not know where the bottom is and to buy without knowing is speculating.