What Is Dollar-Cost-Averaging: Is It the Best Way to Invest? was written by Linda Meltzer and originally appeared on Savoteur. It has been republished with permission.
Want excellent investment advice? Buy low, sell high.
This desirable but overly simplified strategy means you should buy shares at a low price and sell them when they are at a higher price, resulting in a profit on the transaction. The problem with such advice is that you'll have to know when to call a bottom in down markets so you can make purchases or when the market is peaking to make a profit.
Therein lies the rub for most investors, which is challenging to achieve.
Why? Because we are busy human beings with emotional biases that react to volatile markets. When the market is in a downturn, people often fear more declines and sell their shares. And when stocks rise, people get FOMO (fear of missing out) and may rush in to invest. For many of us, emotions and stress levels play a role in constructing our investment portfolio, making dollar-cost-averaging a legitimate strategy.
What is Dollar-Cost-Averaging?
To succeed financially, you must establish long-term investment strategies. Avoid making common mistakes when there is substantial market volatility like trying to time the market, chasing the hottest trends, being overconfident, or setting unrealistic goals.
Our emotions get the best of us, especially when making investments. To counter our tendencies to get into trouble, we can adopt a safe and effective strategy for the long term: dollar-cost-averaging.
Dollar-cost-averaging (DCA) is a systematic program of investing equal sums of money at regular intervals regardless of the investment's price. It's a simple approach requiring you to determine two parameters: the fixed amount for each period and how often.
In this approach, you'll automate investing the same fixed dollar amount in the same stock, ETF, or mutual fund at regular intervals over a long time.
As investments tend to increase in price more than they fall, the “cost averaging” means that you purchase more when the price is down and fewer shares when the price is high. Essentially, you are buying most of the shares at below-average costs.
You're Probably Already Using the DCA Approach
This strategy provides a disciplined approach, taking the guesswork out of investment timing and avoiding the outside events that may cause short-term gyration in the market. DCA is similar to the buy-and-hold investment strategies that look past short-term noise in the market.
You're probably already using dollar-cost-averaging for your 401K plans, individual retirement savings accounts (Roth IRAs or traditional IRAs), and employee stock ownership plans.
Suppose you use Acorns, the micro-investing app, Greenlight app, or other fintech companies that use a Round-ups feature or recurring investments. When making purchases using a linked debit card, the spare change from the transaction rounds up to the nearest dollar and goes into your investment account. Users will benefit from using the dollar-cost-average strategy.
Besides these plans, a dividend reinvestment plan (DRIP) can carry out dollar cost averaging. Many well-known companies, such as Coca-Cola, allow investors to purchase shares of stock on a dollar-cost basis directly from them through a DRIP program managed by the Direct Stock Purchase Plan Clearinghouse. This allows you to avoid going through a brokerage firm. DRIP strategies help investors reinvest their dividends.
Although dollar-cost-averaging is not an exciting way to invest, it tends to enable investors to buy at “below-average” prices. For example, you may want to invest $100 into shares of a specific company each month, whether the market is fluctuating, declining, or rising.
At the end of six months, you invested $600 into shares for an average dollar cost of $3.87 per share. Had you invested $600 all at once as a lump sum, your average price would be $5 per share, above the average price of $3.87. We'll discuss investing in lump sum payments below.
MONTH $ AMOUNT SHARE PRICE SHARES PURCHASED
|MONTH||$ AMOUNT||SHARE PRICE||SHARES PURCHASED|
Benefits of Dollar-Cost-Averages
The DCA approach minimizes risk and is desirable for investors with low-risk tolerance. It automatically buys more shares through downturns and lower prices, decreasing the average share price. Essentially, it provides short-term downside protection by taking advantage of gyrations.
This simple strategy enhances investor discipline.
Investors are making purchases at regular intervals and fixed amounts instead of poorly timed lump sum investments. Investors aren't timing the market, a challenge for most sophisticated investors. They can set up automated contributions based on preferred parameters like they do for their retirement accounts.
Warren Buffett is a fan of the low-cost-average approach. Whether he is buying shares for his own portfolio or recommending that investors buy low-cost index funds of the S&P 500, he often says investors should not make their purchases all at once.
Help You Lower Your Cost Basis
Dollar-Cost-Averages reduce the average cost of shares purchased over a relatively long term. Investors will buy more shares at a fixed amount when the market goes down. While it doesn't eliminate losses, this strategy limits them during times of declining prices.
Reduce Emotional Biases
DCA counters investor psychology sometimes called behavioral finance. We often buy at the “wrong” time and second-guess our moves in the market. Investors experience loss aversion, a cognitive bias that describes individuals who feel the pain of losses significantly more than the pleasure gains in the stock they own.
Similarly, anchoring bias causes us to rely on the first piece of information we know rather than new information. For example, an investor may refuse to sell a stock at a lower price than their purchase. They may cling to the higher price they paid, even though new information reveals an unfavorable direction for the company.
Dollar-Cost-Averages provide a mechanism that eliminates emotional biases that may undermine our portfolio strategy.
Less Focus on Short-Term Market Volatility
Market volatility can be stressful. DCA smooths out the volatility by regularly making lower-priced share purchases. Investors can better ignore the daily noise affecting the market.
Contributing money to your portfolio during a sharp market downturn is often the best time to purchase stocks.
The DCA approach allows investors to remain in the market rather than staying out and missing the bottom. You can't wait for “the dust to settle” as there are no bright lights that tell you when to wade back into the market.
Disadvantages of Dollar-Cost-Averaging
A More Conservative Approach
DCA's lack of glamour may bore some investors who prefer actively trading stocks for shorter timeframes. The Dollar-Cost-Averages strategy tends to be a more conservative way to invest than making lump sum investments.
Investors May Forfeit Higher Returns
Lower risks tend to generate lower returns. Therefore DCA investors may forfeit higher returns associated with the riskier lump sum investment strategy.
Investors will generate higher returns if the asset price rises by investing a lump sum at once at a lower price rather than over regular intervals. In the DCA strategy, you may buy fewer shares than if you make a more significant investment upfront.
There May be Opportunity Costs
When implementing the DCA approach, you may hold the funds in cash or money markets (cash-equivalents) at meager returns, causing opportunity costs. You can avoid this scenario by contributing to your portfolio from your paycheck as you do for your retirement accounts.
Comparing Performances of DCA to Lump Sum Investing
An alternative to DCA is lump sum investing. This is when you invest a lump sum immediately, unlike DCA, which invests equal amounts at intervals.
A Northwestern team analyzed rolling, 10-year returns of $1 million invested immediately in the U.S. markets versus dollar-cost averaging. In the dollar-cost averaging scenario, the money was invested evenly over 12 months and then held for the remaining nine years. They varied the portfolio composition from 100% equities or 100% fixed income, including money markets, and a 60/40 split between equities and fixed income.
They found that lump sum investing a $1 million windfall all at once generated better cumulative total returns at the end of 10 years than dollar-cost-averaging almost 75 percent of the time. This was regardless of asset allocation.
However, another study pointed out that the length of time for DCA made a difference. Over 36-month intervals, the lump sum beat the dollar cost, averaging more than 90 percent of the time. However, the results were much closer over six-month time frames.
DCA works better for six to twelve months, whereas lump sum investing works better with large windfalls such as an inheritance or insurance and more extended periods.
Who Should Consider a Dollar-Cost-Averaging Strategy
- The DCA approach works best for beginning and risk-averse investors who want to participate in the market and can't stomach accumulating losses.
- They are comfortable with lower returns as a trade-off for higher risk and stress.
- Investors don't need to time their purchases.
- They prefer automating contributions to build their portfolio and doing the same for their retirement accounts.
Although DCA works with individual stocks, buying ETFs or mutual funds is desirable for diversification purposes.
Dollar-cost-averaging is a conservative approach to investing in the market, reducing risk, stress, and emotional biases. It is desirable for investors who are less tolerant of market volatility but want to participate in the market.