A common strategy for brokers, financial advisors, and investment managers is the use of Dollar-Cost Averaging (DCA). This is the practice of buying a set dollar amount of an investment or basket of investments at a pre-determined interval over a pre-determined length of time. So, for example, instead of buying $6,000 of XYZ stock in one lump-sum, you buy $1,000 worth each month for the next six months.
Because of the fixed dollar amount you end up buying more shares at lower price points and fewer shares at higher price points. It’s an easy way to convince someone to invest who is a bit timid about the market, and also a great way for the advisor to cover their own ass. If the stock goes down it’s now a good thing because we can buy more at the lower price. Below is an example:
Had you purchased all of the shares up front for $50 per share you would have only received 120 shares and your total investment would be worth only $5,714.40 at the market price of $47.62 in month six — a loss of $285.60. However, with the DCA program in this example you would have 142 shares purchased at an average price of $42.25 worth $6,762.04 in month six — a gain of $762.04.
Magic, right? The only problem is most of the time it doesn’t work out that way.
The purported benefit of DCA is probably one of the most perpetuated myths in the investing world. First, DCA requires more transactions and that means you are likely going to be paying more in trading costs.
Secondly, DCA is only a more beneficial approach than lump-sum investing if the average purchase price ends up being less than the purchase price available in the beginning. The reality, however, is stocks tend to go up more than they go down. There would not be too many investors out there if this wasn’t the case.
Vanguard published an excellent white paper on DCA in 2012 that looked at U.S. stock and bond market data from 1926-2011. They found the relative probability of a lump-sum investment (LSI) in stocks outperforming a 12-month DCA program was 66%. It was a similar 65% probability when investing in the bond market and 67% when investing in a 60% stock/40% bond portfolio. They even looked at returns on a risk-adjusted basis and still found LSI to be the better option.
The study also found the longer the DCA program is in place, the more likely it is to underperform the lump-sum strategy. Other studies I’ve seen have shown very similar results.
Be careful not to confuse the above concerning DCA with the benefits of investing a portion of your income at regular intervals — like you would with a 401k contribution out of each of your paychecks. They are not the same thing. The first deals with immediately available sums of cash, while the second deals with money you receive over time.
If a DCA program can convince an investor to get into the market when they otherwise wouldn’t, then by all means use it but try to keep the program short. DCA should not be used a default strategy, and if it is to be used the lower chance of a benefit should be disclosed.
Historically, people have been better off two times out of three investing the whole nut day one instead of dollar-cost averaging over a one-year period, and I’ll take those odds any day.
