Dollar-cost averaging (DCA) is an investment strategy of allocating an amount of money at a regular interval (e.g. monthly or quarterly), instead of investing the full sum of money at one time. The strategy can also be used over a short period of less than a year, or even for a longer term goal like retirement. DCA is generally used for more volatile investment asset classes like stocks and equity funds.
There isn’t a holy grail investment strategy that would suit every financial situation. To help you understand the basics of DCA, in this article we will compare the differences between Dollar-cost averaging (DCA) and Lump Sum Investing (LSI) strategies as a whole.
Pros of Dollar-cost Averaging
1. Lowers Your Risks
“Time in the market is more important than timing the market” is a well-known investment advice, because the reality is – no one can truly time the market. If you have a sum of money to invest and buy into an investment all at once, you may risk buying it at its peak. DCA means you split that same sum into equal amounts, buying in over time to lower that risk. This smooths out the price you pay for your investment over time since prices fluctuate.
This strategy also allows you to purchase more shares when the price is low and fewer units when the price is high as the dollar amount of money invested stays the same for each period. This is helpful in mitigating pre-crisis risks. In this 2015 article, DAC outperformed LSI based on a period of investing between 2006 – 2016. DAC strategy would have produced a 6.2% total return, which is a pretty poor return during 10 years but compared with the stock’s negative 54.6% total return, the DAC strategy helped to reduce risk. DAC also provides smaller swings with a smaller standard deviation 2% to your portfolio as compared to LSI’s 3.3%.
2. Takes Emotions out of Decisions
Since you have set out the plan for your money to be placed at set intervals, your emotions won’t have to play a part in your investment process. There is also no need to decide on the “golden” moment to make a huge decision of whether you are buying in at “a good price”. Naturally this helps you sleep better at night since you can avoid making fear-driven decisions about whether to invest at all.
3. Disciplined Wealth Accumulation
DCA automates your investment process which helps make your planning more disciplined and consistent. For instance, you may set up your incoming crediting account to automatically pay your trading account. This allows most people to invest with little administrative effort. Setting this up once allows your monthly disposable income to work for you automatically. You can start this with as little as $100 per month.
Growing your money, no matter how small the amount, is better than leaving it idle in your bank account that yields little to no returns.
Cons of Dollar-cost Averaging
1. Higher Costs of Transactions
Investing a lump sum often results in a smaller fee incurred compared to investing over several transactions. The fees e.g. $10 minimum charge per trade or 0.03%, whichever is higher, will accumulate as you are investing multiple times. The percentage of cost out of the sum invested is higher when you make smaller investments. Keep this in mind when you choose the platform to execute your DCA investment strategy.
2. Dividend Paying Assets
If you are investing in dividend paying assets, having a smaller sum at the start of your DCA deprives you of the dividend yield on your remaining uninvested cash. For instance, if you want to invest $10,000 into a 1% yield per quarter fund over 10 months ($1000 each month) during the first month, you’ll only get dividend income on 10% of your investable money. Your first dividend income after the first quarter would be for just $30, not the $100 you would get by investing all of your money at once.
3. Lump Sum Investing Perform Better Over Time
Studies suggest that LSI into a diversified portfolio provides higher average returns than DCA over long term investment horizons of at least 10 years in some assets such as S&P 500. This is because the equity market moves on an upward trend over time, hence investing earlier puts your money to work earlier, and the long time horizon assumes you ride out the short term losses.
Here’s a table of how DCA and LSI strategies would perform in 2 market scenarios
In this scenario when the market was volatile, DCA strategy resulted in an average purchase price per unit of $9.62 ($10,000 / 1,039 units). While lump sum strategy’s purchase price per unit was $10. This reflects that the DCA strategy yielded a positive result despite the market having 0% gain after 5 months.
So when is dollar-cost averaging right for you?
As you can see from the above examples, during times of uncertain market environment, when you don’t have a lump sum of cash to invest or if you’re worried that your purchase price might be too expensive, dollar-cost averaging can certainly be a smart investment strategy to adopt while keeping your risks low.
Now, how do you start a dollar-cost averaging investment plan?
In this scenario when the market is on an upward trend, DCA strategy resulted in an average purchase price per unit of $11.21 ($10,000 / 892 units). While Lump Sum strategy’s purchase price per unit was $8. This reflects that the Lump Sum strategy yielded way better results during this bull run.
The steps are simple:
Decide how much money you want to invest in a particular stock or fund.
Decide on your investment time horizon.
Decide how often you want to make your investments: daily, weekly, monthly, quarterly, annually. The shorter your investment time horizon, the shorter your intervals should be.
Calculate the number of periods there are based on steps 2 and 3.
Divide the total amount you want to invest by the number of periods to determine the amount you should set for each trade.
If the platform allows, set your investment account to trade automatically each period, otherwise, use the good old calendar to remind yourself.
Whichever strategy you adopt, Dollar-Cost Averaging or Lump Sum Investing, the above should not be the sole investment mandates to follow, proper asset allocation should be considered and implemented alongside with either strategies.