Most everyone has heard the term “dollar cost averaging” (DCA) as a way to invest money into the market. Unfortunately, there is much misunderstanding about the topic including the validity of the process.
Let’s look at an example of DCA. Lets say you just inherited $20,000 and you decided to invest it in the stock market. Once you have determined a proper asset allocation (mix of investments appropriate for your risk tolerance, risk capacity and goals) you could invest it all at once or do “dollar cost averaging” into the securities by purchasing a set dollar amount of securities at pre-determined intervals. An example would be investing $1666.67 on the first of each month for 12 months.
Dollar cost averaging is NOT the same as a pre-determined savings. Here you have decided to save $1666.67 a month from your income so that at the end of the year you have accumulated $20,000. Many people use this pre-determined savings technique for contributions to their retirement savings plans, as well as regular investment accounts, but remember this is not DCA.
The stated goal of DCA is to purchase more shares when the price is low, and fewer shares what the price is high thus providing a lower total average cost per share of the investment and giving the investor a lower overall cost over time.
There are several problems with this goal. The first is that no one intends to put money into an investment that they expect to go down. Dollar cost averaging is predicated on the fact that the investor expects share price to be lower in the future than it is currently. Historic price information proves that shares go up more often than they go down.
Go to: http://www.moneychimp.com/features/dollar_cost.htm to see this for yourself. There is a very good online calculator that will allow you to see the difference between lump sum investing vs. dollar cost averaging using the S&P 500 going back to 1950. The majority of the time, investors are better off with lump sum investing.
The second problem of dollar cost averaging is it fails to address the often higher transaction costs of making more numerous smaller acquisitions. This may be why many investment companies encourage you to cost average when it leads to higher fees for their companies.
The topic “dollar cost averaging” is a popular search engine title that is used to garner increased revenues for certain online companies. Take for example About.com: Investing for Beginners. Joshua Kennon writes “DCA is a technique that drastically reduces market risk”. He sites no evidence for this statement. This site is sponsored by banks wishing you to open accounts, investment companies wanting to sell you stocks, others that wish to sell you bonds and lastly those that wish you to dollar cost average into their investments. Sponsors usually pay based on how many people view the site, not on the accuracy of what is posted.
Suze Orman has claimed that DCA “reduces exposure to certain forms of financial risk”. However, others believe “DCA is nothing more than a marketing gimmick and not a sound investment strategy”. Keep in mind Susie makes her living from marketing her books, TV appearances, CDs and other products.
On the other hand, we have economists, including Nobel Prize winner Kenneth Fama who states that if you have determined the proper allocation for your investments you are better served to be in the proper allocation sooner rather than later. DCA delays the proper allocation.
It has also been academically shown that you get higher investment returns by having the proper allocation rather than when or how you buy into the market
Professor Fama believes that DCA is a method to ease the investors worries of making a larger investment in the market versus a number of smaller investments over time. He states that dollar cost averaging may give investors a better overall “investment experience” but may not give a better “investment performance”.
The long and the short of DCA is that “it does not make financial sense to DCA, but if you sleep better at night not worrying as much, it probably won’t hurt you in the long run”.
Michael Chamberlain CFP®
CA Registered Investment Advisor
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This article is for informational purposes and should not be taken as legal, tax or investment advice.