DOES IT REALLY WORK?

 

By Aaron A. Anderson, CFA, Partner & Financial Analyst

 

Dollar cost averaging (DCA). It’s a financial term you may have heard thrown around as something beneficial, but rarely explained. What is it? Is it really useful? When should it be used and when should it be avoided? Hopefully by the end of this focus article, you will have a good understanding of the strategy and when you may want to employ it.

The name is a good summary of what dollar cost averaging is. The idea behind DCA is that you invest a specific dollar amount into an investment over a period of time instead of going “all in” on that investment right from the start [1]. The idea is that if stocks go down in price during that timeframe, then you are buying some shares cheaper than you would have if you had just purchased them all in the beginning.

Mathematically, this makes sense in a volatile market. Since the goal of this article is to discuss DCA in an accessible way, and a bunch of math doesn’t align with that, I’m including a hypothetical example that assumes volatility in the footnotes to show the details of the math involved [2]. The conclusion of that example: investing it all in a lump sum yields the investor 1500 shares at an average cost per share of $20, but using DCA, the investor ends up with 1525 shares at an average cost per share of $19.67.

Sounds great, we should DCA on every purchase, right? Not exactly. While doing research to keep up with the latest ideas, I came across this article and its follow up article about the disadvantage of dollar cost averaging. Please feel free to read the articles for yourself, but in case your eyes glazed over behind the statistics, the point is that since the market tends to rise on average, the volatility that is necessary for DCA to be effective doesn’t materialize over the long term. Instead, as an investor delays, the price of shares continues to rise (again, on average) and so shares purchased later are more expensive and the average cost per share increases.

In the second article, the author goes even further and shows that dollar cost averaging into stocks (as represented by the S&P 500) gives you a 50-50 chance of underperforming an all bond portfolio (as represented by 5-yr US Treasuries) over 24 months. Basically, one is taking on a higher risk portfolio of all stocks to have an even chance of performing equal to or worse than a more conservative all bond portfolio because of DCA [3]. Obviously, higher risk, same reward does not make a good investment.

Umm OK, so we shouldn’t use DCA then? Again, not exactly. There are a few times when dollar cost averaging can be very useful:

• Methodical Investing: Except in rare circumstances of an inheritance, large bonus at work, or winning the lottery, most of us do not have large lump sums to invest. Through purposeful budgeting and saving, we tend to accumulate wealth in smaller amounts consistently over our lifetimes. In that case, it is much better to invest that as you go than to wait until a lump sum is created and trying to invest it all at once. Wait… didn’t the articles say that investing a lump sum is better? Yes, but the point was that the market goes up on average and so waiting is the real problem. Investing a lump sum is better than waiting to use DCA but using DCA as a methodical accumulation technique is better than waiting to invest a lump sum.
• Investor Psychology: sometimes it is difficult mentally to invest a large sum all at once. No matter what the math tells you, the thought of going 100% into an investment scares you and keeps you awake at night. If so, then DCA is a good way of methodically getting into the investment without putting all your money immediately at risk.
• Volatile Market: If you believe the market will be volatile due to uncertainty, or will be going down, then DCA is a good way to get into the market somewhat if it happens to go up but leaves money on the sidelines in case it goes down. As we saw from our example, this volatility can work in your favor. Of course, the issue with this is that you are trying to time the market which even the best prognosticators cannot do with consistency.

The best conclusion you can draw from the articles applies as well to working on the computer as it does to financial planning: “save early, save often”. Unfortunately, none of us has a time machine that we can use to go back in time and start saving, so we can adjust that to “save now, save often”. No matter how old you are, today is the day to start saving, and once you start, you need to regularly continue investing as well. Reach out to your financial advisor today to get started and if you don’t have one, we would love to fill that role for you.

 

Initially Written: 10/18/2019

[1] Note that there is a similar strategy called “averaging down”. With dollar cost averaging, the dollar amount invested is fixed over each buy and the number of shares bought changes. The strategy is employed even if the market goes up. With averaging down, the number of shares is fixed and the amount invested changes. This strategy is employed when the market goes down to get more shares cheaper than the initial purchase. [Back]

[2] DCA example: let’s say Stock X costs $20 per share on Jan. 1, $16 per share on Feb 1, and $25 per share on Mar 1. If one invests $30K into the stock on Jan. 1, one would purchase $30000/$20 = 1500 shares and the average cost per share would be $20. If instead one used DCA, one would buy $10000/$20 = 500 shares on Jan 1, $10000/$16 = 625 shares on Feb 1, and $10000/$25 = 400 shares on Mar 1. This would give a total of 1525 shares at an average cost of $30000/1525 = $19.67 per share. [Back]

[3] Right or wrong, US Treasuries are typically considered a risk-free investment in the theoretical investing world since they are backed by the full faith and credit of the US government and so there is no default risk. As we have discussed in previous articles, however, there are still risks involved that could make them riskier than stocks. For example, if you must sell them before maturity in a rising interest rate environment, there is principal risk since they would have to be sold at a discount. Even if you hold them to maturity, there is still purchasing power risk since you are locked into a lower interest rate. Please see “Focus on Bonds” for more information. [Back]

The opinions expressed in this article are those of the author and may not reflect the views of LPL Financial.  This article is not intended to provide investment guidance to any individual.  You should review your situation and strategies with your personal advisor before acting on this or any investment advice.  Any economic forecasts expressed or implied in this article may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. All investing involves risk including loss of principal. Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets. The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. All indices are unmanaged and may not be invested into directly.