3 Investment Principles Every Young Person Should Know: #3 Dollar-Cost Averaging

by Cameron Schaefer on November 17, 2007

DCAContinuing on in the 3 Investment Principles series (If you haven’t caught the first two here they are: Time Value of Money and Pay Yourself First) we come to the final principle: Dollar-Cost Averaging (DCA). The aim of DCA is to reduce the risk associated with a single, large investment by spreading out the investing (and risk) over time. Everyone has heard the token financial advice, “buy low, sell high.” Seems simple enough, but in reality no one can predict exactly when a stock will bottom out. By investing a fixed dollar amount at regular intervals (weekly, monthly, etc.) regardless of share price, you will end up buying more shares when the price is low and less when the price is high, thereby maximizing your total return.

An example of this from youngmoney.com:

“Dollar cost averaging works like this: systematic investments are made to an investment account. For this example we will say on a monthly basis. To keep things simple we will also say that the investment account is allocated 100% into one growth fund. We will use $100 as the monthly investment amount. Now, depending on how the market is doing that fund’s price is going to fluctuate from day to day. So let’s look at a six-month example in the table below.

Month

Price

Shares Purchased

1

20

5

2

16

6.25

3

10

10

4

5

20

5

10

10

6

25

4

In the example above, you have invested $600 and your account is now worth $791.73. Over the six-month period, you paid an average of $14.33 per share. If you would have taken all $600 and purchased the shares at the beginning of the six months, you would have purchased 30 shares and your account would now be worth only $750. For this example, using dollar cost averaging has increased your account by over 5%! Of course the above scenario is just one example of using dollar cost averaging. There are many.”

This isn’t to say that this method of investing doesn’t have its critics. DCA operates on two assumptions: 1) the investment (stock, mutual fund, etc.) follows an overall positive trend over the investment time frame, meaning, dollar-cost averaging isn’t going to help if the investment you’re putting money into ends up losing value in the long run. 2) If you happen to get extremely lucky and start investing at the bottom of a long-term price trend you would be better off buying a lump sum…good luck timing the market!! John Wagonner explains in USA Today, “Dollar-cost averaging typically does best when an investment goes sideways or down for years and then, at the end of the period, suddenly breaks to the upside.”

As is the case with nearly everything in finance, time frame matters. “Regardless of the amount of money that you have to invest, dollar-cost averaging is a long-term strategy,” explains Jim McWhinney for Investopedia.com, “While financial markets are in a constant state of flux, they tend to movie in the same general direction over fairly long periods of time. Bear markets and bull markets can last for months, if not year. Because of these trends, dollar-cost averaging is generally not a particularly valuable short-term strategy.”

In the end I like DCA for one simple reason, it builds a habit pattern of investing in season and out of season. Its very easy to form the wrong habits in an affluent culture like our own. It seems everyone, but you, always has the latest gadget, toy, car, etc. Spending, saving, investing are all habits. The purpose of this 3-part series on investment principles is to help make good habit patterns, ones that create wealth and enable you to live the High Life.

{ 5 comments… read them below or add one }

Dividend growth investor February 15, 2008 at 2:30 pm

I think that DCA is an inferior strategy. If you follow the link to my website, you will see that over the past 20 years DCA has produced inferior returns to a lump sum buy and hold. You decrease your risk with DCA, but you also decrease your return. Once again, no free lunch on WallStreet.

Cameron Schaefer February 15, 2008 at 5:12 pm

Interesting. I have two thoughts. First, while you’re spreading out the regular interval by investing once a year, its still DCA in the sense that you’re making purchases at a regular interval regardless of share price, whether its once a month, or once a year. True buy and hold would be purchasing X amount of shares of VFINX in 1988 and holding them until 2007 (not purchasing anything in between) vs. purchasing shares at regular intervals during that 20 years adding up to X amount. I would be interested to see the results of this comparison.

Second, buy and hold is completely dependent on timing the market. For example, if an investor bought $1200 of VFINX sometime in 2000 and held them until present he would be far worse off than the investor that spread out the $1200 over the 8 year period, making multiple investments along the way…this obviously due to the popping of the dot com bubble in 2000. You could also find time periods when buy and hold would crush DCA (like from the bottom of the 2000 bust until present)…but again, buy and hold is completely dependent on timing.

Now, I admit that DCA works out best when there are some large dips in price in the midst of long term positive growth. Without some good dips in price during your investing time frame then buy and hold beats DCA hands down. The problem, as you pointed out, is that few actually have a large sum early on in life to be able to plop down in the market. I think that’s probably the core issue which makes DCA such a good idea.

I completely agree with your last statement though. Always better to have money working for you in the market regardless of investing method, rather than not investing at all.

Interested to hear your response…I admit, I still have a lot to learn when it comes to investing so I welcome the debate.

Dividend Growth Investor May 21, 2008 at 10:37 am

DCA outperformed the market in only 20% of the years.
That sounds like a bad strategy to me. Of course, you could have invested at the top of the market in 2000 in a lump sum, versus DCA-ing, but if you look at the results year by year, as I did, it seems like DCA reduces the risk while also minimizing return..

Larry Clockwant November 23, 2008 at 6:10 pm

Now is a great time for buying stocks.

http://www.youtube.com/watch?v=xKlMl4II3_0

Anon March 12, 2009 at 12:14 pm

Most of the time Return and Risk are proportional. The lower the risk the lower the return, hence CD’s and T-Bills are low risk and low return and Stocks have higher risk and higher return. Investment strategies tend to work the same way.

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