Financial pundits often tout dollar-cost averaging (DCA) as a method to manage risk in the markets. However, they don’t mention that the risk this technique is managing is the investor’s own bad behavior. DCA does lower your risk, but just like other methods of lowering risk, it also lowers your expected returns.
What is Dollar-Cost Averaging?
First, let's define what DCA actually is, because a lot of people are confused.
Dollar-Cost Averaging is Not Regular Pay Check Deposits
Many investors mistakenly think they are DCA when they have money taken out of their paycheck each month and deposited into a mutual fund in their 401(k). However, this is called periodic investing and is the manner in which most investors gradually make investments throughout their careers. This is not DCA because the investor has no choice other than to invest this way. He can’t invest all his money up front because he hasn’t yet made most of the money he will invest.
Dollar-Cost Averaging is Spreading Out a Lump Sum Investment
DCA is an alternative to investing a lump sum all at once. Consider an investor who inherits $1 million or some other sum that is large in proportion to the remainder of his portfolio. She has a choice. She can invest the money all at once (lump sum) or she can invest it a little at a time, say $100,000 a month for 10 months (DCA). A proponent of DCA would demonstrate the following:
If a lump sum investor used $1 million to buy an investment at $10 per share, she would have 100,000 shares of that investment. A DCA investor might make investments over the next 10 months as follows:
The DCA investor ends up with an extra 4,449 shares because she bought many of her shares at less than $10. Furthermore, DCA will help an investor to stay the course with her investing plan and minimize possible regret if the investment goes down in value shortly after buying it. DCA also helps the investor avoid “analysis paralysis” where an investor does nothing because she cannot decide what to do.
Problems With Dollar-Cost Averaging
1. The market generally goes up
Obviously, when the price of an investment is trending down or see-sawing, buying shares later instead of now is going to work out well. But there is no way to know what the market is going to do in advance, and historical data demonstrates that a typical investment goes up in value over time. If you didn’t expect an investment to go up in value, why would you buy it anyway?
If you look at a gradually rising market (as we’ve had for the last four-and-a-half years), the results come out very differently.
You still end up with the same 100,000 shares with the lump sum investment, but you only get 85,709 with DCA. If you look at the S&P 500 stock index from 1926 to 2011 (86 years), you’ll see that the index (counting dividends) ended higher at the end of the year than at the beginning in 62 of those years, or about 72% of the time. If the future resembles the past, waiting to buy means you’ll be buying at higher prices.
2. You miss out on the dividends for those shares that weren’t invested originally
Consider an investment that puts out a quarterly dividend of 0.5%. If you own 100,000 shares, that’s $500. If you were DCA and thus only owned 30,000 shares, that’s only $150. Even if the share price remained exactly the same all year, the lump sum investor would come out about $600 ahead. Sure, he may have had the uninvested money in his bank account or money market fund for those 10 months, but given current rates, that wouldn’t have paid anywhere near $600 in interest.
3. It's a Hassle and Opens the Door to Behavioral Mistakes
Lump sum investing is very easy. You get the money and you invest it at the first available opportunity. When you decide to DCA, you then have to decide how much to invest at a time and over what period. You also have to put in the time, effort and money to make many different transactions.
Proponents argue that a DCA investor can minimize regret if his initial investment goes down in value because the next month he gets to buy even more shares at a lower price. I would argue that not only does it cost more money to make many separate transactions, but it also gives the investor many more opportunities to doubt himself and make a behavioral mistake.
4. Lower Expected Returns
DCA does help control risk. Your money is exposed to market risks for less time. If there were a major market correction in month three of your DCA plan you would only have a third of your money exposed to it and would thus lose less money. However, as a general rule, the market pays you to take risk. When you take less risk, you have lower expected returns.
Unfortunately, at the end of the DCA period, all of your money is exposed to those same market forces. If you were uncomfortable exposing your money to those risks earlier, why would you be more comfortable now? It is simply a behavioral bias, with no logic behind it. Investing with your emotions instead of your mind is a recipe for disaster.
A Better Way to Control Risk Than Dollar-Cost Averaging
If you are uncomfortable with a high percentage of your portfolio invested in risky assets, the answer isn’t to invest a high percentage of your portfolio into risky assets over time. The answer is to place a smaller percentage of your money into risky assets.
Instead of investing in a portfolio of 80% risky assets (such as stocks) and 20% less risky assets (such as bonds) over 10 months, perhaps you should lump sum into a portfolio of 50% stocks and 50% bonds right now, and then maintain and rebalance that portfolio over time. Developing a written investment plan and then following that plan is the way successful investors reach their goals. You should only change that plan in response to changes in your life causing your need, ability, or desire to take risk to change, not in response to market or news events.
DCA is a method of managing your own emotions to avoid regret, inaction, and reactive selling of investments at market lows. However, most investors, when given a choice between a smaller chance of avoiding regret and a larger chance of having more money in the end, will choose to manage their own emotions and invest their lump sum all at once as their investment plan decrees.
What do you think? Do you routinely dollar-cost-average in lump sums? Why or why not? Comment below!
I dollar cost average all my monthly retirement contributions the same as 99% of the population that has automatic paycheck witholding of 401k contributions. However I wouldn’t DCA a large lump sum investment and don’t really understand the logic. I would invest any windfalls or lump sums 100% immediately according to my my asset allocation. Can anyone explain the difference between these different scenarios?
1. You receive a $12,000 windfall and decide to invest it in an Vanguard Total Stock Market (VTSMX) and DCA your purchase by buying $1000 of VTSMX monthly for the next 12 months.
2. You inherit $12000 of VTXMX from your great aunt but you want to DCA your windfall so you sell your shares and DCA $1000 worth of VTSMX monthly for the next 12 months.
3. You already own $12000 worth of VTSMX but want to DCA so you sell your shares and buy them back $1000 at a time for the next 12 months.
If you would do #1 or #2 but not #3 please explain why #1 makes sense but not #2 or #3.
As someone coming out of training, I think DCA works as I’m trying to catch up for the decade of lost investments. Later down the road, I’d probably do lump sum investing.
I think you’re mistaking DCA for periodic investing. If you don’t have a lump sum, you don’t have a DCA vs lump sum decision to make.
Not necessarily. Someone who wants to contribute to an IRA or other account could chose to set up a periodic monthly deposit or could wait until the end of the year when taxes are due and make a single lump sum payment. You don’t have to have the lump sum in hand for this issue to arise.
But I agree, usually comes up when someone has a large lump sum to invest and is nervous about going “all in” at one time due to the risk that the market could drop. I think that is more a problem of asset allocation though, because there is nothing different about the market risk for new money compared to existing money one already has invested.
That would be an interesting investment strategy. Why wait until the end of the year? Why not the end of the decade? 🙂
I DCA our IRAs for a few reasons, but namely because at the end of the day its accounted for in the budget, and I don’t have to think about it. As as we have already discussed here, timing the market is a poor investment strategy. DCA offers regular investing at a simple, but proven effective strategy. I really differ in opinion with the arguments made in this article. 99% of investors can easily make ~400/mo investment if its set up in their budget to be a set “cost”, but saving to make $5000 at one time brings out the second guessing to the timing of the investment in probably everyone, and often leads to misinformed emotional investing.
As mentioned in the post, you’re talking about periodic investing. DCA is really inappropriately used to describe what you’re doing with your IRAs. If you were going to DCA your IRAs, you’d take your monthly $400 and invest $100 a week, instead of all $400 as soon as you get it. What you’re doing is periodically investing your available lump sums.
To clarify, I do invest $100/wk in a vangaurd retirement mutal fund.
So you get paid monthly, plan to invest $400 a month into this fund by DCAing in $100 a week? I agree, that’s DCA.
There was a study done by an academic at least 10 years ago. I remember discussing it with my financial advisor, but do not recall the name of the study, nor its author.
The main conclusion: since people are so very, very, very bad at market timing the time to make your IRA contribution is the first business day of January ….. not part in January, February, March, etc. And certainly not one lump sum right when you calculate your taxes and decide it’s time to put money into an IRA, say April 13th.
Your money has more time to grow. And time for growth trumped DCA every time. (The study did the actual calculations using low-cost index mutual funds and high cost load funds, etc)
After I read that study, I no longer DCA’d anything.
While I agree, in the end lump sum investing at the start of the year may be marginally better in the end, this means that you have $5500 or $11k if married to dump into an IRA.
I believe I have seen that same study. I couldn’t find it, but I found something even better I thought I would share http://www.moneychimp.com/features/dollar_cost.htm It’s a website where you can play around with lump sum investing (say you have a winfall) and DCA. Depending on the year, either won out.
Generally I’m against stop/loss orders because it is contrary to the highly popular ‘buy low sell high’ in that it forces you to sell low. Yes, it may prevent you from a catastrophic loss but it also might kill you with a whipsaw. If you buy at 100 with a 90 stop loss and you hit your loss so it sells, then it jumps back up to 100, do you buy back in again? Almost always its better to ride it up or down.
I will recommend stop/loss orders in situations where people are dependent upon the money for their daily needs such as someone who is retired withdrawing 4% and could be really hurt in situations like 2008. That being said, someone retired should not have a substantial portion of their portfolio in equities anyway.
Oops, commented on the wrong section.
Also against dollar cost averaging except in very volatile times. Market generally goes up, unless there is a high risk of a fallout, better to just throw it all in at once.
Hi Jim Dahle and fellow readers,
Is anyone here doing value averaging (VA) rather than plain dollar cost averaging (DCA)? Is it really more superior to DCA? If it is, is it worth doing it? And how does one maintain his asset allocation of stocks to bonds when using value averaging? We seem to have a hard time meeting our value path and at the same time maintaining our asset allocation (75 % stocks, 25% bonds) I’d appreciate any input. Thanks!
I occasionally run into someone doing value averaging. I assume you’ve read the book by the same name. Bernstein has lots of nice things to say about it. I’m not convinced it is worth the additional complexity. I don’t think it’s a wrong thing to do, but not something I want to spend much time or effort on it. You might want to ask about it in the forum as few will see this comment.
Thank you for your input! Yes, we read the book by Michael Edleson. My spouse and I have different views about it. I see it as too complex and also very difficult to maintain our desired asset allocation. On the other hand, my spouse really wants to give it a shot but in so doing, we would not exactly meet our desired asset allocation by a few percentage points. Ok, I will post my question in the forum. Thanks again!!!
Whatever you guys choose to do, you need to be on the same page about it.
Thanks again! We are having a friendly debate about it =)
Honestly, it matters more that whatever you do you do it together than whether you value average or not. There are far worse battles to lose.
I have been now labeled both a jerk ( re: DAF) and a wimp by the WCI. I shudder to think what will be next. 😉
LOL
If no one clicks on it…..
Hi Everyone –
Was hoping for some help grasping a concept regarding #2 above : missing out on dividends by not investing a lump sum earlier.
Specifically, when #2 is compared with this vanguard link about “buying a dividend” that explains how a fund price drops by the amount of the dividend, therefore making things essentially even, minus the tax owed for the dividend.
https://investor.vanguard.com/investing/taxes/buying-dividend
I now understand what is meant by “tax drag”. I used to think when those dividends showed up, that it was just “bonus” money, and didn’t realize that share prices were recalibrated.
Is #2 referring to bond funds?
I’m still not clear on the pros/cons of the dividends for index stock funds. Are there any pros?
Thanks everyone.
It’s just referring to the fact that you’re missing out on returns when you hold money in cash. That applies to stock and bond funds.
Buying a dividend can be a poor move in a taxable account, but you have to weigh it against cash drag if you’re waiting to invest. Obviously it doesn’t matter if you buy the dividend in tax-protected.
Honestly, it’s way better tax wise to be able to control when you get money and pay taxes, so in that respect, dividends are bad. You’re better off declaring your own dividend and selling shares. But the hard core dividend folks feel that when companies pay dividends that forces management to focus more on the shareholder’s return. A dividend tilt is also a way to get a value tilt, which historically has had higher returns.
Lump sum investors do better in rising markets…….but does anyone here have a crystal ball? Imagine being an investor preparing for retirement in Japan and investing at the top of the bubble. If we DCA’d we would have a chance of regaining losses, and do roughly as after the fall the market roughly went sideways for a bit with some up and down variance. Thus a lump sum investor who invested at that very inopportune time would have found that their retirement money would have been essentially eaten by the market.
The market is set up in such a way as to transfer wealth from the impatient to the patient. (paraphrased from Warren Buffett) DCA lowers market timing risk, but it also lowers returns to a degree. If you are heavy on stocks, such as a 90/10 stock/bond portfolio you need that risk mitigation, if you have a conservative asset allocation and plan to rebalance at least every few years then you could probably do fine with lump sum investing. Rebalancing itself lowers risk while slightly lowering returns according to a study by John C. Bogle.
DCA and rebalancing are both tools that lower timing risks and or volatility while also lowering risk. Rebalancing and DCA on more conservative portfolios, such as the classic 60/40 portfolio may not add as much value as they would to a portfolio heavier in risk.
DCA is not just a method of managing emotions, it does lower actual risk, in example investing at the top of a long term fall, see the Japanese market example. If I invested a lump sum at the top of the bubble without knowing, even though twenty years or so has passed, I would still not have even broke even on that investment.
Asset allocation, dollar cost averaging, rebalancing, and diversification are all valid risk and volatility management tools, and should be used appropriately for the individual investor’s personal financial situation. Don’t knock DCA, it does its job of managing portfolio volatility and risk reasonably well.
I don’t assume any market will necessarily rise forever, or fall forever, the markets will do what they always do: fluctuate.
Thanks for the education on the difference between DCA and periodic investing and, more importantly, how DCA can be obviated by investing in a portfolio with appropriate asset allocation. This has helped me decide what to do with a “windfall” (cash on hand for a specific purpose that is no longer needed).
Hi Dr Dahle: Coming to the personal finance game late after finishing my training and mistakenly holding onto my savings thinking it would go towards the downpayment of a house (in a coastal area where it turns out I am priced out of the market). I’m now sitting on a lump sum (that would have gone to a potential down payment), however wondering if the stock market bubble is just about to burst and whether it makes sense to intermittently invest over the next year as opposed to lump sum invest now when stock market prices seem like their at a high that can’t sustain itself for much longer. Or is this exactly what you’ve been cautioning against trying to time a market? Thanks for what you do.
Crystal ball is cloudy. Buy a house when your personal and professional life is stable, even if you have to use a physician mortgage to do it. Try to keep the mortgage to less than 2X your gross income, although it might be okay to stretch to 3-4X in a high cost of living area, just know that it will mean financial sacrifice elsewhere.
Invest when you have the money. I invest every month. Sometimes that means buying in March 2009 or March 2020. Sometimes it means buying in June 2008 or February 2020 or July 2021. But I really can’t predict the future and over the course of my life, I buy low at least as often as I buy high. Try to be like Dory from that fish movie…Just keep investing…just keep investing….
Don’t beat yourself up when you occasionally invest just before the market crashes. It is going to happen, probably multiple times in your career.
But yes, this post says invest now rather than DCA over the next year. But it’s your money, do what you want.
Call me a wimp. Actually, call my husband and me both wimps.
With our inability to travel due to COVID-19, we have experienced a gradual growth of discretionary cash on hand. To deal with this, we have been Dollar Cost Averaging into VTSAX–weekly.
Even before the current bear market, we were transferring money. As the market has declined, we have been increasing our weekly transfers. Good, better, best? Maybe transferring a lump sum is, on average, the best strategy. That said, I suspect that Dollar Cost Averaging is better than doing nothing and keeping excessive idle cash stashed on the sidelines.
Gradual growth of discretionary cash (i.e. money you make each month and invest each month) is not dollar cost averaging. It’s periodic investing. We all do that. Dollar cost averaging is when you receive a $1 million inheritance and instead of investing it all now, you invest it over a year.
I agree that DCA is better than not investing. So if one needs that psychological crutch to invest, then by all means use it. But recognize it for what it is. At some point, the entire lump sum is invested and if the market goes down at that point, there is no “protection.”