My Failed Attempt to Understand Dollar Cost Averaging

What is Dollar Cost Averaging

Are there real benefits to dollar cost averaging or is it a myth? Confused yet?

Are you into dollar cost averaging?

Chances are you may already be doing it. Especially if you contribute regularly to a retirement account at your workplace.

In this post I’ll attempt to tackle this basic tenant of investing. I’m not a pro at this material, but I’ve researched it and hopefully I can give you some “every man” perspective.

Dollar cost averaging is the act of investing your money on a set schedule, with a fixed amount or percentage, regardless of market conditions. For instance, you decide that you are going to invest in a stock, mutual fund, other other investment each month with a contribution of $100 until you reach some goal or pre-determined date.

Using this method, your $100 buys more or less depending on the current value of your investment.

The way I see it, is it’s not so much of an intentional strategy as it is a resulting strategy. Most people don’t intend to participate in this strategy. They don’t seek it out, per se. They just start investing and it’s what naturally happens.

If dollar cost averaging sounds a lot like what you already do with your company 401K, you would be right. Most people already take part in this “strategy”. Although, some choose to call it “regular contributions.”

It aligns perfectly with the goals of the long-term, buy-and-hold investor, who is only able to invest a certain amount each month.

In contrast, does dollar cost averaging make sense for a person with a lump sum of $10,000 sitting around? I not so sure that it does. If you have $10,000 sitting in a bank account that you want to invest, you should just go invest it…now. Right?

If you are buying into a single stock, and you have no idea about the true value of the stock, then it might be wise to hedge your bets and spread out your purchases.

However, if you are buying into a diverse set of investments with your $10,000 (like every wise buy-and-hold investor should do), then you are already reducing much of your risk, right? I’m not so sure about this part, but it seems logical. If you have an opinion, let me know in the comments below.

One thing is for sure, most people don’t have $10,000 lying around to have to make this choice. As I said above, most people participate in this strategy just because. Still, let’s look at the benefits.

What I Like About Dollar Cost Averaging

It fits into most financial lifestyles. Most people earn money on a periodic basis through employment. It’s natural to take a portion of these earnings and invest them for the future. Most successful investors will even apply some type of automation to this process to be sure it gets done.

Also, most people aren’t sophisiticated enough to guess when the market will rise and fall. Last time I checked, not too many people can get that right over the long haul. So this strategy makes a lot of sense for your average investor who just wants a solid return with little risk over the long-term.

It takes the emotion out of your investing. Investing in U.S. companies via the stock market is not without it’s risks. The market is constantly moving, and even if your investments are well diversified, the market as a whole can see huge ups and downs from time to time.

By investing on a schedule, you are intentionally ignoring day-to-day market prices, and putting trust into the idea that over time (a long time), a diversified portfolio will win more than it loses. The person investing with this strategy doesn’t panic when he/she sees a down market, they just enjoy the fact that they can now buy more with their money.

Note: it could be argued that those first two points are really just benefits of buy-and-hold investing. The real, supposed benefit to dollar cost averaging comes from reduced risk. Here’s where I start talking out of my ars a little bit.

Reduces the risk that you’ll pay too much for investments. I would argue that if we’re talking about a single investment made by a short-term investor (less than 5 years), then dollar cost averaging (over a 1 or 2 year period) reduces the risk that you’ll buy too high. However, you and I aren’t into single investments for the short-term. Many studies have shown that dollar cost averaging doesn’t reduce risk for the typical investor.

Does dollar cost averaging mean a better return on your investment? No. But it does mean you’ll be paying less than the average price for your shares across a set period of time. See this handy-dandy chart:

Month of InvestmentAmount InvestedShare PriceShares PurchasedAvg. Price/ShareAvg. Cost/ShareShares Owned
January$100$10.0010.000$10.00$10.0010.000
February$100$6.0016.667$8.00$7.5026.667
March$100$8.0012.500$8.00$7.6639.167
April$100$11.009.091$8.75$8.2948.258
May$100$7.0014.286$8.40$7.9962.544
June$100$10.0010.000$8.67$8.2772.544
Total$100N/A72.544$8.67$8.2772.544

There are two ways to look at these results: (1) You are a fool for buying your stocks at any point other than at the February price of $6.00, or (2) you are smart that you actually paid .40 cents less per share than the average of price/share over the entire period AND at least you didn’t pay $11.00 for everything. How you choose to view it is ultimately up to you.

One thing for sure is that dollar cost averaging doesn’t beat lump sum investing in the long haul. The market rises over the long-haul. Because of this, if you are a long-term investor, it’s better to get your money into the market as quick as possible.

How to Start Your Own Dollar Cost Averaging Strategy

Like I said above, most of you guys are already on this train. But if you aren’t and want to get started. Here’s what you do.

  1. Get a job with a 401K and/or open up a brokerage account (retirement or taxable).
  2. Pick a diversified set of investments based on your risk tolerance and timeline.
  3. Start automatically investing in those investments each month.
  4. Don’t stop till you reach your savings or retirement goals.

What does dollar cost averaging mean to you? How do you define it? Is it a total scam of an idea, or a sound investing strategy?

Photo by kevindooley

Last Edited: December 5, 2011 @ 12:58 pmThe content of ptmoney.com is for general information purposes only and does not constitute professional advice. Visitors to ptmoney.com should not act upon the content or information without first seeking appropriate professional advice. In accordance with the latest FTC guidelines, we declare that we have a financial relationship with every company mentioned on this site.
About Philip Taylor

Philip Taylor, aka "PT", is a CPA, financial writer, FinCon CEO, and husband and father of three. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

Comments

  1. Hmmm…lots to think about here. You’re right, most people don’t choose dollar cost averaging, they just do it because they invest as the money becomes available to them and it results in dca.

    A couple of things:

    You can start dca without a job and 401k. We’re self-employed, but we still receive our money monthly and invest that way.

    Also, I think dca works not only with individual stocks, but with any investment where the price fluctuates. Mutual funds are a good example.

    I like the concept of dca a lot and if you had a flat amount to invest for a long period of time, I still wonder if it might not be a good idea to dca it over 6 months or a year. It’s all about buying low and selling high and dca helps with the ‘buy low’ part of the equation.

  2. Dollar-cost-averaging is a mechanical strategy that has much to offer the typical investor. It’s easy to understand, eliminates timing difficulties, and removes emotions from decision-making.
    All investors should have a system they use to approach investing. The ultimate goal of this system is to help the investor effectively make consistent investing decisions without being tossed to and fro by market conditions.

  3. @Julie – Yeah, I struggled to be as concise as I wanted to be with this post. Good point about the self-employed and mutual funds. I don’t disagree with you there. What I should have said was “if you have regular employment” and “if you invest in a single investment”. Thanks for chiming in.

  4. Kathryn C says:

    I think this is a great time for dollar cost averaging, even with funds, because there’s so much volatility in the market.

  5. We are deliberately putting something like 6% of our gross income in an earmarked savings account right now, rather than put it into our IRA. There is a slight chance we might want to have that extra little bit available in the near future, since we’re considering a move several states away and a new job. And then, we’ll try and buy a house once that dust settles.

    So as long as we get it into our IRA by April 2012, I’m good with that. I know we could miss out on a market upswing and stuff, but this is how we’re gunna do it.

    And I suppose we could just put it in the IRA and take some out for the down payment, since you can do that if you wanted…but I dunno. Still thinking on this one!