If you’ve ever taken stock advice anytime during your life, then surely you’ve been led to believe dollar-cost averaging is the smartest way to invest.
Upon setting up my first Schwab account in 1988 in Oakland, CA, this was one term I heard often.
That’s when we could walk into the brokerage, and the large ticker with bulbs above the long front desk would continuously scroll the stocks.
Too bad I didn’t take pictures. Before we go any further on this important topic, let’s ensure we agree while clarifying our premise and answering the following question.
What Is Dollar Cost Averaging?
By definition, dollar-cost averaging (DCA) is an investment strategy where the investor will divide up the total amount to be invested along periodic purchases.
Dollar-cost averaging is a tool an investor can use to build savings and wealth over a long period of time. It is also a way designed for an investor to neutralize and try to reduce short-term volatility in the broader equity markets.
An investor will choose any asset on the exchange, such as a single security, an ETF or index fund, in an effort to reduce the severity of volatility on their overall purchase.
The purchases occur no matter what the asset’s price may be, and they make the purchase at regular and predetermined equal intervals.
The core purpose of this strategy removes lots of the detailed work of attempting to time the market in order to make purchases of funds at the best prices.
Dollar-cost averaging can also be called and known as the constant dollar plan.
Let’s say you have $60,000 to invest. First you select a time period over which to deploy your $60,000, let’s say the next 12 months. Then you divide your money by 12 and each month you invest $5,000.
By using this approach, you are creating a protective barrier. So, if the market plunges right after your first investment, you’ll have 11 more periods that your total investment might perform better. Sounds great, right?
What Is Dollar Cost Averaging Really Saying?
By dollar-cost averaging (DCA) you are really saying the market is going to drop.
That you aren’t putting all your money in at once because you believe the market is too high.
By dollar cost averaging and betting the market will drop, the true premise is in saving yourself some pain.
For any given year, the odds of this happening are only 23%. This percentage odds also assume you’re putting your money into an index fund.
If you’ve read some of my other articles and papers, then you know my advice is to almost never choose one single stock to invest into in the first place.
Why Is Dollar Cost Averaging Not Good?
Two downsides of dollar-cost averaging are first, buying more frequently adds to trading costs. Yet, with brokerages that charge very little to trade, this expense becomes mostly negligible.
If you’re investing longer term, these fees should become very small relative to your overall portfolio. This is assuming you are buying for the long term and not trading in and out of the stock markets.
Second, the big negative is that by dollar-cost averaging, you may not capitalize on gains you otherwise would have earned if you had invested in a lump-sum purchase while the stock rises.
As we talked about earlier, the success of that large purchase relies on timing the market correctly. We know investors, including myself admittedly, are historically terrible at predicting short-term movement of a stock or the market, unless you’re Warren Buffett.
By using our example, we talked about in previous paragraphs of investing the $60,000 over 12 months with allotments of $5,000 does eliminate the risk of investing all at once.
However, the problem is that it only works as long as the market drops and the average cost of your shares over the 12 month investing period remains on average below the cost of the shares the day you began.
If the market rises, you’ll surely come out behind. You are, basically, trading one risk (that the market drops after you invest) with another risk of the market continuing to rise while you DCA therefore ending up paying more for your investment shares.
This scenario has most people asking the question of which risk is more likely?
If you’ve read my earlier posts, books or papers, then you know that the market always goes up but it is a rollercoaster and no one can really predict what it will do on any specific day, week, month or year.
The other principle of good and sound investing to know is that it goes up more often than it goes down.
Simply look at the period between 1970 and 2013, the market was up 33 out of 43 of those years. That’s 77% of the time the market was up.
DCA Can Work For Or Against
There are many scenarios of DCA floating around in social media circles and on other blogs and websites.
The crucial point and key takeaway is that it’s a strategy assuming the market will drop more than it will rise over the time period we purchase the equities during the DCA period.
Does this really make sense? We know the market rises more than it falls.
The best way to look at our question is to break our investment down into specifics. If the investor is buying only one stock, then DCA may have a greater chance of resisting losses.
However, if an index fund is chosen to use the DCA strategy with, then the method is probably going to work against the investor.
Of course like any investment nobody really knows for sure and if they say they do then beware.
In most scenarios, a lump-sum purchase beats dollar-cost averaging.
Generally speaking, however, dollar-cost averaging provides several key benefits that can result in better returns. DCA can benefit you by:
- Avoid losses when not timing the market properly
- Take roller coaster of emotions out of investing
- Help you think longer term when investing in the equities market
All in all, dollar-cost averaging helps investors stay away from their psychological biases. If you are a very emotional investor then this is where you can surely benefit from dollar-cost averaging.
Investors generally swing between fear and greed and are prone to making emotional trading decisions as the market oscillates.
Keep in mind, however, if you’re using the dollar-cost averaging strategy, you’ll be buying when people are selling on fear because of the predetermined choice to buy no matter what.
You will be getting a good price and setting yourself up for strong long-term gains. The market tends to go up over time as we previously discussed.
Although lump sum investing is better overall than dollar-cost averaging, you can recognize that if in a bear market, it is a great long-term opportunity, rather than a threat.
What To Do Instead Of Dollar Cost Averaging
One of the most significant people in the world of investing was John Bogle. He has probably done more for the personal investor than anyone who has ever lived.
He’s earned this recognition by allowing us to bypass the large fees and to educate us on how the stock market works early on.
He founded Vanguard. The one fund I totally recommend of theirs above all is the index fund VTSAX.
Take a look at it and get on board with Vanguard. Their fees are super low, keeping your margin favorable and on your side pays off big time in the long run.
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