Dollar Cost Averaging (DCA)
One often-misunderstood investment strategy is dollar cost averaging. While some financial planners insist the approach is a great way to save for the future, others say there is no advantage to using this technique. We've examined both sides of this story, and have concluded that advocates, as well as opponents, are correct in their thinking.
In this article, we're going to dispel the myth surrounding dollar cost averaging. We'll do so by first explaining how this investment strategy is thought to work. Next, we'll demonstrate the approach using example calculations. We'll also explain why some financial planners don't believe this savings model works. Finally, we'll clarify when it's appropriate for individuals to use this investing approach.
Dollar Cost Averaging Technique
Also known as constant dollar planning, and pound cost averaging in the U.K., dollar cost averaging (DCA), is a technique that calls for investing equal dollar amounts over a specific timeline at a fixed frequency. The strategy is typically utilized when purchasing shares of common stock or mutual funds. The explanation normally provided when using the approach is this:
By investing a fixed amount (for example, $250) each month or week, fewer shares of stock are purchased when prices are high, and more shares are purchased when prices are low. By doing so, the average cost per share is lowered, and the risk associated with making a lump-sum purchase when prices are high is eliminated.
But what exactly is the risk associated with a lump-sum purchase? Let's say the investor believes the stock or mutual fund they're purchasing is going to increase in value over time. That same investor also knows this stock is subject to short-term price fluctuations.The investor's poor timing might result in a sub-optimal purchase during one of these short-term price spikes. When that happens, their overall return on investment is lowered. This is the risk associated with lump-sum investments.
Now that we have a better understanding of this investment technique, let's see how this works in practice, using two examples.
Example 1: Increasing Stock Prices
In this first example, the investor is looking to purchase shares of a mutual fund in their 401(k) retirement plan. Once a month, they invest $250 into this fund. We're also going to create a fictitious stock that sells for $10 per share in January, and steadily increases in price by 1% per month. This scenario is depicted in the table below:
In this example, the investor purchased 284.19 shares for $3,000, or an average of $10.56 per share. Taking a DCA approach doesn't seem to work in the scenario. The investor could have purchased 300 shares of stock if they made a lump-sum purchase in January.
Example 2: Decreasing Stock Prices
In this second example, the investor is once again looking to purchase shares of a mutual fund for their 401(k). Once a month, they invest $250 into this fund. We're also going to create a fictitious stock that sells for $10 per share in January and steadily decreases in price by 1% per month. This scenario is depicted in the table below:
In this second example, the investor purchased 317.24 shares for $3,000 or an average of $9.46 per share. Taking a DCA approach seems to work in the above scenario. The investor would have only owned 300 shares of stock if they made a lump-sum purchase in January.
The Dollar Cost Averaging Myth
Many popular financial advisors completely embrace the DCA approach to investing, and advise their followers to execute this strategy when buying stocks or mutual funds. Unfortunately, many stock analysts, and theorists, denounce the approach as pure myth.
The most noteworthy counter-argument to the dollar cost averaging approach was first published by George M. Constantinides. In "A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy," published in the Journal of Financial and Quantitative Analysis back in June 1979, professor Constantinides demonstrated mathematically that dollar cost averaging was inferior to lump sum investing.
The argument presented by professor Constantinides is that DCA was believed to reduce risk of making a single sub-optimal decision at one point in time. That is, when a stock is purchased in a lump-sum fashion, that stock may be "over-priced" at that particular point in time.
Professor Constantinides argued that DCA relies on a series of decisions; some, or all, of which may also be sub-optimal. Furthermore, he argued the numerous transaction costs associated with this approach erodes investment returns.
Pros and Cons
We already know one of the disadvantages of dollar cost averaging. It can increase transaction costs. It's also been mathematically demonstrated the strategy does not reduce risk. Investors typically purchase a stock when they believe the price per share will increase over time. In the example above we learned that when prices increase over time, the technique results in a higher average stock price than a lump sum purchase.
These are three very good reasons to avoid dollar cost averaging and purchase stocks using the lump-sum approach. If all this is true, then why do so many financial advisors advocate the approach?
One of the assumptions made when comparing dollar cost averaging to a lump-sum purchase is the investor has the money necessary to make a one-time purchase. That will not always be true. When employees fund their 401(k) plans, they're making regularly scheduled investments through payroll deductions. This allows them to make investments faster, which puts their money to work sooner than waiting until enough money is saved to make a lump-sum purchase.
The biggest advantage of dollar cost averaging is that it brings discipline to investing. It's a great way to "force" people to put money away for the future. By making smaller purchases over time, the investor is less likely to "miss" the money they're earmarking for retirement. This is the very reason so many advisors advocate the approach.
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