Dollar-cost averaging (DCA) is touted as one of the more prudent investment strategies for investors by many, if not most financial professionals. Most conservative and some aggressive investors enjoy the concept as well. I guess you could consider DCA as one of the sacred cows of the investment world.
What Is Dollar Cost Averaging?
We define DCA as the act of buying a stock or asset with a fixed-dollar amount paid at fixed intervals. For instance, if you had $200,000 cash sitting around to invest, you could use DCA over a 10-month period and invest $20,000 a month into your holding. The main reason to use this strategy is to potentially lessen risk. Should you instead invest the full $200,000 on day one, and the market drops 20% soon after, you would already be in the hole by $40,000. Using a DCA strategy would hopefully mitigate any immediate losses. Note that there are studies that show that lump sum investing may actually be “better” in the long run, but that would be the case in a perpetually rising market.
Dollar Cost Average (DCA) to Minimize Risk
Beyond risk management, the concept of Dollar Cost Averaging offers a chance to get a lower, average purchase price over a period of time rather than a large, one-time purchase. But, what people fail to realize is that the market tends to go up more often than it goes down (shocking, right?). The longer you utilize Dollar Cost Averaging, the less likely your investment price will be lower. Let’s look, for example, at the short-term data for any month-to-month frequency between 1926 and August 2009. The stock market rose — rather than fell — from month to month about 62% of the time. If you were to look at 12-month data for that same time period, the stock market increased seventy-three out of one hundred times. You can see that over time, DCA doesn’t really work from a lower cost standpoint. Of course, the future may be different from the past… who knows?
My Take On Dollar Cost Averaging
My typical recommendation for DCA is not to try to achieve a lower average investment price (though that would be a nice benefit). Instead, investors should use Dollar Cost Averaging more as a risk mitigation tool. I have suggested DCA in the past for people with a large lump sum or those who are sitting on a large amount of cash. In those instances, a DCA approach may be better than one large deposit on any given day. Of course, keep in mind that this is for equities only.
For example, I had a client who had $250,000 to invest with another $100,000 on the way. Based on the recommended, target portfolio, she was going to have about 80% equity exposure and 20% bond exposure. Not knowing how to invest the money, she eventually decided to utilize a DCA strategy. She made an initial investment into the stock portfolio and then the rest throughout the course of the following year. “But, why not the bonds?” you might ask. She invested the bond portion of her portfolio all at one time. Why? Well, first the downside potential and risk of a significant drop in bond prices is much less than with equities. Second, the whole purpose of bonds (other than income potential) is really to offset equity risk by acting as a hedge against stock market volatility. So, why wait? My contention is that you should not wait on the bond side and only consider DCA for the stock side.
Dollar Cost Averaging: Concept vs. Application
As mentioned, rarely will dollar cost averaging achieve a lower, overall pricing strategy, but it does have moderate risk-management potential. Further analysis leads me to believe that a DCA strategy just might be better in concept than in application. My scrutiny leads me to believe that for the conservative investor, we are not necessarily mitigating risk, but instead just delaying that risk until a later period. For the risk-averse investors who are wary of the market, we are simply delaying the time until they are fully invested in the market. For those more aggressive investors who are comfortable with stock market risk and volatility, we are providing them a delay that presents opportunity costs (the chance of missing out on market gains) for only a moderate, downside protection benefit. Since we do not know if or when the markets will correct or drop, Dollar Cost Averaging becomes similar to a market timing strategy. In essence, by not going “all in,” aren’t we implying we know what the market direction might be? And since the market goes up more often than down, it seems that DCA is just a waste of time based on the mere chance that the market will go down.
The Bottom Line
All in all, I am not convinced that DCA does what we (yes, me included) profess to be prudent investing. Perhaps there are some benefits for investors who are very risk-averse, but need a realized rate of return higher than their risk tolerance allows. In that case, easing into the market may help from an investor psychology perspective. But, for those simply trying to get a better overall purchase price or hedge against a large drop in the market, the strategy is probably misguided and overrated. As always, it really just comes down to your choice and comfort level.