Many investors use dollar cost averaging (DCA) to reduce their average cost per share and lower the risk of making a substantial investment just before the market plummets. Although DCA offers some peace of mind, it also comes at a price.
What is DCA?
DCA simply means investing an available lump sum of money in equal installments over time. For example, if you receive a $50,000 after-tax bonus at work, but are uncomfortable investing it all at once, you might invest $10,000 per month for five months.
As asset prices fluctuate, investing the same dollar amount each period ensures that you buy more shares when prices are low and fewer shares when prices are high. In other words, you reduce your average cost per share over time. If you are risk-averse, DCA tends to minimize the odds that you will invest a large amount just before a market drop. DCA also helps remove emotions from your investment strategy. By investing the same amount each period, you will be less tempted to try to “time” it.
What’s the downside?
Although DCA can lower your risk, it may also cause you to miss out on potentially higher returns. That is because your money is held in cash or cash equivalents for a longer period while you wait to invest it. Not only do you risk losing the potential gains you might have earned had you invested in higher-returning securities sooner, but there is the risk that cash investments will not keep pace with inflation. This can erode your returns even further.
The alternative is lump sum investing (LSI), or investing the entire amount immediately—typically in a mix of stocks and bonds. The volatility of these investments increases your risk when purchased all at once, but they outperform the DCA approach more often than not. According to a study by investment company Vanguard, LSI historically outperforms DCA about two-thirds of the time in a 12-month period. That advantage also increases as the time frame increases.
There is another potential disadvantage of DCA. Depending on the type of investment, it may involve higher brokerage fees than LSI.
What’s your time horizon?
If your investment time horizon is longer, LSI may be more effective than DCA, although it is important to note that you can lose money using either strategy. If you are uncomfortable with the risk of LSI, another potential approach is to ensure that your portfolio’s target asset allocation is appropriate given your risk tolerance.