Dollar Cost Averaging - Still a Good Idea?
Friday June 12, 2009
When you dollar cost average (DCA), you invest a certain sum of money in a specific investment (or investments) on a pre-set schedule. For example, you might arrange to put $100 into mutual fund X on the first day of every month. The primary advantage of dollar cost averaging is that you will buy more shares when the price of the investment is low and fewer shares when it is comparably higher. You automatically use DCA when you sign up for your 401(k) plan.
So, when wouldn't DCA be a good idea?
Turns out, about two-thirds of the time. Since the stock market generally goes up (notwithstanding the nearly two years of current market pain), by waiting to invest a lump sum of money, you miss out on more of the long-term price appreciation. Still, if and when you have a lump sum to invest, you don't know if we're about to enter a period of time when you would be better off investing all at once (two-thirds of such situations) or doing so over several months or longer (one-third of similar occasions). Like everything else, using dollar cost averaging is a trade-off between risk and reward. What would you do? What do you actually do? What do you think about dollar cost averaging?
So, when wouldn't DCA be a good idea?
Turns out, about two-thirds of the time. Since the stock market generally goes up (notwithstanding the nearly two years of current market pain), by waiting to invest a lump sum of money, you miss out on more of the long-term price appreciation. Still, if and when you have a lump sum to invest, you don't know if we're about to enter a period of time when you would be better off investing all at once (two-thirds of such situations) or doing so over several months or longer (one-third of similar occasions). Like everything else, using dollar cost averaging is a trade-off between risk and reward. What would you do? What do you actually do? What do you think about dollar cost averaging?
DCA is a great idea. Your clAim that it is wrong 2/3 of the time is bogus. It rests on the presumption that the investor can time the market; which, as Benjamin Graham showed, you cAn’t.
Ice, Thanks for the comment. I don’t believe in market timing at all. If I did, then DCA would be wrong 100% of the time. The 2/3 comes from from the fact that sometimes you’d be better off investing a lump sum all at once simply because the market performs particularly well after the starting point.
I see. I must admit that I am still finding my way through investing having read books and studied it for some time, my knowledge is far from comprehensive.
My understanding:
The 67% accounts for the fact that the market is up generally bull for that period, correct? You therefore have a greater chance of investing at the right time than wrong. DCA mitigates this by investing over regular intervals.
My question: Does the 2/3s account for bear markets? Do markets tend to drop farther than they rise, erasing any benefits from lump-sum? I apologize if my question is poorly worded, and can clarify if needed. Thanks!
Ice, your understanding is right. The overall upward trend means, more often than not, investing today all at once is better than waiting. But it’s also the wrong strategy in plenty of situations and we don’t know which is which except in hindsight. The 2/3 accounts for bear market and bull markets.
Let’s stop and think about it…DCA is trying to time the market. It is just a type of diversification strategy. However, you can time the market.
When we all saw real estate at its peak (or close to it), someone that prescribed to the Modern Portfolio Theory (along with DCA) they MUST put a portion of their portfolio into real estate. The same with financials…as Bear Sterns, Merril, Lehman all were about to fail, who DCA’d into them?
That is why the old models of “DCA, Buy and Hold, MPT” are all out the window. You can get stable returns with little to no risk without exposing you entire portfolio to the whims of Wall Street…as the models of old require!
Nice piece. I think dollar cost investing works well provided the investor who is profiled understands the possible different outcomes that can result from market direction & frequency used compared to lump sum investing. Volatility of the investment instrument used is also a highly contributing factor on the returns derived from this strategy. With a basic understanding of markets, savvy investors should consider actively shifting between lump sum investing & dollar cost averaging throughout their investing horizon.
Mickey
My Informative Article:
Dollar Cost Averaging Explained Here
Can you DCA out of the market as you approach and actually retire. How do you time getting out of the market?
@JAB: A great, albeit comprehensive, question. The best strategy is to have one and stick with it. If you determine you need, for example, $1,000 every month from your investments, you can set up a process whereby you sell $1,000 total a month of investment X, Y, and Z. This insures that you don’t try to time the market as to when the “right” time is to sell, instead selling based on your needs. That said, and why this is just a cursory answer: little of your needed retirement funds should be in the market anyway – too risky. Most of your short-term needs should be invested far more safely. If you have a sophisticated level of wealth, working with an unbiased, hourly advisor, can be a good investment him or herself.
Retireplan: I agree and thank you. I have sufficient cash reserves for the short term and I am trying to wait out the market’s recovery. I held on when it dropped and have faith I will get back to where I was in 2007-8. I am 60 and my investments would be discribed as moderate growth. My dilemma is that I know that at my age I move move to safer ground, but at the same time I am trying to avoid locking in losses with a move. I agree that I should involve my professional. I plan to retire at 65 and work at something else until 70.
It’s all Greek to me…I’ll let my accountant sort it all out (my head hurts just thinking about it…gotta drink?!).
Ole (aka “Olympia”) Guy: I agree that is another way of planing. Are you old enought to remember an Olympia Beer can opener—pre-poptop!
Leaving your finances to your accountant is like saying you are leaving your health to your doctor. Not a good idea.
90+ % of people should never retire. If you were to have $1M in a 60/40 (stocks/bonds) portfolio, you could reasonably take somewhere between 3-5% per year out and have it last for approximately 30 years. As the principle starts to dwindle, the stress increases and then when the market has its “correction” you jump out…which only speeds up the process of liquidating your assets that much faster.
Instead, people should find something they love and make a business out of it. This enables them to get a little income, have some tax deductions, and control their taxes better. It also gives their life meaning and takes much of the stress of depleting their assets away.