The Ins and Outs of Dollar Cost Averaging
There has been a lot of discussion regarding the effectiveness of dollar cost averaging these days. The chatter has grown louder especially since the release of reports by investment professionals such as Vanguard, highlighting the benefits of lump sum investing – Click here to read more about the findings.
The truth of the matter is they are both useful strategies depending upon an investor’s situation and goals. Although Vanguard researchers and some historical evidence suggests investors may earn more by diving into the market with a lump sum (primarily due to the fact that overall markets have gone up more than they have gone down), there is still a lot of compelling reasons to apply a dollar cost averaging approach.
Let’s start with the true definition of this strategy. Dollar Cost Averaging: Investing in the market in equal installments at regular intervals. This is essentially what you do every time a portion of your paycheck flows into your 401k or other employer-sponsored retirement plan every pay period. Let’s look at some of the benefits of this strategy:
- It is a simple and effective means to placing money aside in an automatic pilot manner.
- Forces investors to buy more shares when prices are low and fewer when prices are high, which will generally decrease your average price per share.
- Tends to be the victor when compared with lump sum investing during volatile or falling markets.
- Vanguard compared investing $1M in lump sum with investing it over time using the dollar cost averaging approach. Vanguard analyzed over 1000 rolling 12 month periods and found lump sum investors would have seen their portfolios decline in value during 22% of the time, resulting in a loss of $84,000 during that period of time. Those who employed the dollar cost averaging approach experienced losses 18% of the time, resulting in a typical loss of about $57,000.
- I can’t give one side and not divulge the other. During strong markets, dollar cost averaging resulted in about 19% less than lump sum investing, and in a typical market this strategy may cost investors about 3.6% of their holdings.
- Dollar cost averaging minimizes regret (Many times investors will drop lump sum amounts into the market right before a market downturn due to the difficulty in timing the markets) With dollar cost averaging you aren’t concerned with timing the markets and achieving high octane returns. You are more concerned with being able to sleep at night knowing there is a strategy in place that can minimize downside risk.
Let’s look at how a portfolio using the dollar cost averaging methodology would react in various markets:
- In a market where prices are rising steadily, a portfolio using dollar cost averaging, will not do as well because the full gain on the price is captured by the full amount of money invested at the start.
- In a market where prices fall steadily, this type of portfolio will lose money, but typically won’t lose as much as the lump sum investing based portfolio.
- In a market where prices fluctuate but return to their starting point, this strategy will typically gain a positive return.
Again, there are of course benefits to lump sum investing if the circumstances are right. However, dollar cost averaging is a great strategy to use to keep you engaged in a disciplined investing plan with the added benefit of easing the psychological and emotional strain associated with the ups and downs of the markets.
It is important to note, although dollar cost averaging can help to reduce timing risks, it does not guarantee a profit and does not guarantee protection against loss. You should consult your financial advisor before implementing an investment strategy.