Building Blocks

Dollar Cost Averaging

 

 

Example

     Assume an investment of $200,000 in an equity, comparing first a lump sum investment and an 8-week DCA approach in the market described below:

Source: Corporate Finance Institute

     Note that greater quantities are purchased when prices are low while fewer quantities are purchased when prices are high.

     Under the lump sum investment, 2,353 shares were purchases at a cost of $85 per share.  With DCA, 2,437 shares were purchased at a cost of $82 per share.

Source: Corporate Finance Institute

     “Timing the market” to purchase at low prices and sell at high prices is a long-term losing strategy.  Dollar cost averaging provides a tool for investment purchases that attempts to reduce the risk of poor market timing.

Risk vs. Return

     Dollar cost averaging reduces the potential impact of market volatility and market timing.  With a series of purchases across time, the negative impact of a falling market is reduced as funds have been set aside for higher quantity purchases at these lower prices.  When the market is rising, the investor has the psychological benefit of appreciated holdings as smaller quantity purchases are made at higher prices.

     The downside to DCA revolves around the potential missed opportunity for asset appreciation while funds are invested across the time period.  The overall market, as described previously, generally goes through longer sustained periods of rising prices than of falling prices.  By investing in a lump sum, funds are applied to the investment vehicle for a longer time period, which historically has led to increased returns.

     Lump sum investing entails higher risk with the benefit of potentially higher reward.  Dollar cost averaging reduces risk and average cost, though at the expense of potentially higher returns.

Financial Impact

     Dollar cost averaging ensures that investors receive lower average costs when prices are falling.  Greater quantities are purchased when prices are low than when prices are high.

     Trying to time the market in making investments is a risky endeavor that can significantly hurt returns.  The DCA method removes the need to time the market, reducing risk.  While reducing risk may reduce the potential return available from a lump sum investment with good market timing, the avoidance of market timing pitfalls seems well worth the potential opportunity cost.

     Contrarians to dollar cost averaging accurately point out that lump sum investing has historically proven superior to DCA.  This superiority, however, comes with a price tag of increased risk and volatility.  Additionally, the DCA method will incur higher transaction costs as funds are invested across multiple periods.  There is also an inherent cost in the time and energy required to execute the DCA strategy, and then to monitor and track the multi-period investment as compared to a single lump sum.  However, current technology and infrastructure have greatly reduced the added costs of DCA.

Behavioral Effect

     While DCA reduces volatility and market timing risk, the greatest benefits center upon the behavioral aspects of the investment method. 

     By using DCA, many investors are better prepared to weather market downturns, especially as they now view falling markets as opportunities.  Additionally, DCA evokes a disciplined approach to investing.  It encourages investors, as falling markets may be considered buying opportunities, while rising markets show positive returns.  Many have attempted to time the market with purchases and sales, though few have found long-term success.  DCA removes the inclination toward market timing.

     Finally, dollar cost averaging revolves around a mechanical approach to investing.  Decision making based on emotion has repeatedly hurt susceptible investors.  There is a psychological lure to buy when assets are rising and to sell in falling markets.  This tendency to “chase returns” hinders investment performance for many.  DCA provides a disciplined, mechanical, unemotional investment approach with a proven ability to reduce risk when making investments.

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Dollar Cost Averaging