The Investing Class: Dollar-Cost Average

Concept:

Dollar-Cost Average

Technical Definition:

This is the investment of a certain sum of money at regular intervals in the same stock or stocks or in the same investment intermediary. -- Hallman & Rosenbloom, “Private Wealth Management”, pg. 111

Our Definition:

Dollar-Cost Averaging involves investing the same amount of money into the same investments (stocks, mutual funds, ETFs, etc.) on a regular basis over a long period of time.

Why it Matters:

Dollar-Cost Averaging (DCA) typically allows an investor to purchase investments at a lower average cost over their investing time period when compared to the actual average investment price for the same period. This is because the investor is using a fixed dollar amount to buy investments at a regular interval which allows them to buy more shares of the investment when prices are low and fewer shares when prices are high. For example:

Our investor bought 320 shares at a total cost of $5,000 over 5 periods. The average market price paid per share was $17.50. However, once you calculate the average cost of each share the investor owns ($5,000/320 shares), you discover they spent $15.63 on average for each share.

In order for DCA to be most effective, you must consistently invest. If you hesitate and stop investing when the markets go down, you’ll be sorely disappointed in your DCA results because you’re not taking advantage of lower prices.

With that being said, there are those who feel that DCA is not a superior method to invest a large sum of money. Rather, they suggest that you invest the entire sum at once. The reasoning is that, over time, the markets have gone up. If you expect that to continue into the future, then you should expose your money to the markets sooner in order to participate. The same group also feels that DCA is potentially most valuable when the investor is concerned with downside risk, but even then is an inferior method of investing sums of money. A study by Vanguard agrees with this assertion.

Once the concept of DCA is understood, many people are led to believe they are participating in this type of investment plan by making regular 401(k)/403(b) retirement contributions. But, are they really? Upon closer look, the answer is “not technically”. When you make a retirement contribution into your employer-sponsored plan, that money is invested based on instructions you’ve given the custodian. You are, in fact, investing a newly available lump sum of money each and every pay period. DCA, remember, involves investing a portion of money from an existing lump sum over consistent time periods.

The reasonable follow-up question is, “does it really matter if it’s technically DCA or not”? In my opinion, no. While it may not technically meet the definition of DCA, the investor is able to participate in the market efficiently and consistently with a series of lump sum investments. Since the investor is able to consistently contribute these lump sum amounts, they are then able to capitalize when the market prices are lower and make cost-limited investments as markets rise.

One last point of discussion: DCA (or pseudo-DCA-like 401(k) contributions) allow the investor to be less influenced by emotion. While we all know the cardinal rule of investing, buy low and sell high, many people commonly do the opposite. When the markets are continuously reaching new highs and setting records month after month, investors misjudge the amount of risk they’re assuming and want to buy more and more as prices climb higher and higher. Conversely, when the market goes into a decline, investors grow impatient and fearful. Once again, the amount of risk is misjudged and the investor commonly sells when the prices are below the original purchase price. DCA can help prevent this by having the investments scheduled or automated, and remove any requirement that the investor participates in the process.

If You Invest on Your Own:

You can’t time the market. You don’t know when the pullback will come or the next groundbreaking innovation that spurs the entire market higher will occur. You need to be invested in the market with a long-term perspective. If you’re cautious about the foreseeable future, you can mitigate some of that risk by using DCA. Keep in mind, however, that the goal of DCA is still getting you invested in the market. If you’re nervous about potential downward volatility, you should reconsider both your risk tolerance and investment allocation to make sure they’re still appropriate and representative for you.

If You Work With an Advisor:

Your advisor can’t time the market either, despite what they may say. Develop a plan with them to make sure you’re invested into the market in a timely manner. Again, if you’re nervous about where you think the market is going, that’s a great reason to sit down and talk with your advisor. Maybe your concerns are realistic and some action needs to occur. Or, maybe your concerns are entirely realistic, but no action needs to occur (yes, that’s a very reasonable option). One of your advisor’s main jobs is to keep you from making a bad decision that hurts you financially. Listen to them intently and take their advice seriously. Your advisor should have your best interests in mind, and it’s possible that the course of action you need to take is in direct competition with how you feel. You and your advisor will need to determine how to implement the appropriate action while being conscious of your comfort level.