Dollar cost averaging (DCA) is a investing technique designed to reduce risk when purchasing stocks or mutual funds. If you have a 401k with your employer you’re already dollar cost averaging every time they purchase stock for you.
The idea behind dollar cost averaging is to repeatedly invest a set amount of money regardless if your investment goes up or down. If your investment decreases in value, you’ll buy more shares at a cheaper price; if it goes up you’ll be making money on your existing investment. Additionally, dollar cost averaging can reduce your risk and put your investing on autopilot.
Dollar Cost Averaging Reduces Risk
By purchasing small amounts of a stock or mutual fund periodically, like monthly, you reduce the risk of buying when your investment is at its high. Let’s look at an example.
In December of 2019 you received a $10,000 gift and wanted to invest in the stock market since it’s been going up for the last ten years and all your friends are making money. You’ve researched some Mutual Funds and decided on Vanguards S&P 500 fund(VFINX) because the fees are low and you want to invest in an index fund. You have two choices:
- Go to the Vanguard website, sign up for an account, deposit your $10,000 and buy as many shares as you can.
- Go to the Vanguard website, sign up for an account, deposit $3,000 (their minimum for new accounts), in January and dollar cost average the other $7,000 at $1,000 a month for 7 months.
Let’s take a look at option #2:
- 1/17/2020: Your $3,000 is deposited, and you buy 9.76 shares of VFINX at $307.51 a share. With mutual funds you don’t have to buy shares in whole units, you can buy fractional shares (that’s the .76 part)
- 2/14/2020: You’ve set up an automatic investment plan with Vanguard, so they pull $1,000 from your checking account and you buy another 3.20 shares at 312.63. The fund has gone up (from $307.51 to $312.63), so your initial investment made money, but you paid more for this month’s shares.
- 3/20/2020: What’s going on? Your fund dropped to $212.67! You just lost money! Actually, you didn’t lose anything, since you didn’t sell. Markets go up and down. That’s why averaging works. Your $1,000 now buys 4.70 shares, which is more shares than last month.
- 4/17/2020: The fund goes up a bit to $265.58. More than last month, but still less than your initial investment of $3,000. Your $1,000 now buys 3.77 shares.
- 5/15/2020: The price has pretty much stayed the same as last month. At $264.96 you bought 3.77 shares with your $1,000.
- 6/19/2020: The fund price rises to $287.20. Your $1,000 now buys only 3.48 shares. Fewer shares than last month, but you’re making money on your past investments.
- 7/17/2020: You’re a stock market genius! Your mutual fund is up to $297.82 a share. However, your $1,000 is now only buying 3.36 shares.
- 8/14/2020: No one is better than you! The fund jumps to $311.86 a share! You’re making some serious money on your past contributions to the fund, and your $1,000 buys 3.21 shares.
Let’s examine the two options mentioned above; a lump sum investment of $10,000 vs the dollar cost averaging scenerio we just went over.
If we invested a lump sum dollar amount of $10,000 on 1/17/2020 we would have purchased 32.51 shares which would be worth $10,141.45 on our last purchase day of 8/14/2020.
Dollar averaging allowed us to purchase 35.24 shares with the same $10,000 because we were able to buy more shares when the fund dropped in price. Those shares are worth $11,179.55 on 8/14/2020, beating the lum sum investment strategy by $1,038.10.
To be fair, this was an extreme case. I started the scenario right before the market drop in March 2020 to make a point. We can’t predict what the market will do, so investing most or all of our portfolio at the wrong time can really affect your returns.
Some other examples of investing at the wrong time is investing in the S&P 500 during September 2018. It would have taking you eight (8) months to break even, which is not a big deal for long-term investors. However, investing right before the financial crisis in October 2007 would have produced negative returns for over five(5) years. I know many people who chose to sell during that time, instead of buying more shares and dollar cost averaging their way out of it.
Though dollar cost averaging is designed to reduce your risk, in most cases it will not produce the best returns.
Lump Sum Investments Provide A Better Return
In 2012, Vanguard published a study that compared dollar cost averaging and lump sum investing. Vanguard was one of the largest mutual fund companies in the world, and probably one of the biggest recipients of dollar cost averaging investments.
- Three different markets were studied: United States, United Kingdom and Australia.
- It then examined rolling 10 year periods from 1926 to 2011. The rolling periods incremented by month, so over 1,000 10-year rolling periods were looked at.
- Different stock/bond allocations were considered.
- For dollar cost averaging, Vanguard looked at periods ranging from six (6) months to 36 months.
At the end of the 10 year period, lump sum investing beat dollar cost averaging, but not by much. Vanguard found that at the end of the 10-year period, lump sum investing came out ahead about two thirds of the time, with a portfolio value 1.3% to 2.3% higher than dollar cost averaging. If you are strictly a numbers person, and can take your emotions out of investing, then according to this study, lump sum investing is the best approach.
Automate Your Investing
Many of us invest based on our emotions, greed or fear. When the market goes up many tend to buy, and when the market drops they sell. This is the exact opposite of what a prudent investor should do; buy low and sell high.
One of the best features of mutual funds is they let you automate your investments. Once you meet the initial investment, you can set it and forget it. Most mutual fund companies allow you to connect your checking account to your fund and automatically transfer a set amount, say $100 a month and buy shares in a fund. Since funds allow for fractional shares you will be investing your full $100 a month. If your fund pays dividends your can automatically invest those as well.
By automating your investing you can take emotions out of your decision making process and grow your portfolio. You will be surprised how quickly it will increase.
Dollar Value Averaging
Though there are lots of supporters of Dollar Cost Averaging, there are also many critics. Some critics have come up with an alternative called: Dollar Value Averaging (DVA).
With DCA you invest the same amount through a series of recurring purchases, regardless of the price. With DVA you set a dollar target for your portfolio balance to increase regardless of market fluctuations.
Using the previous example, let’s say you want the value of your VFINX mutual fund to increase by $1,000 every month:
- 1/17/2020: Your transfer for $3,000 gets moved, and you buy 9.76 shares of VFINX at $307.51 a share, as before. Your fund starts out at $3,000.
- 2/14/2020: The target value for your fund this month is $4,000 (a $1,000 increase from last month). The fund price increased from $307.51 to $312.63. So your balance is now worth $3049.95 (9.76 shares x $312.63). Since you want the value to increase by $1,000 each month you only need to invest $950.05 ($4,000-$3049.95). You’ve just added 3.04 shares ($950.05/$312.63), for a total of 12.79 shares.
- 3/20/2020: This month’s target value is $5,000. The fund drops to $212.67 this month. The value of your fund is now $2721.04. You need to invest $2,278.96 to keep the value of your fund at the target $5,000.
On 2/14/2020, as your fund increased in value you invested $950 in new shares. However, when the fund decreased in price on 3/20/2020 you invested $2,278.96. That’s the benefit of DCA. You buy more when the price is low, and buy less when it’s high.
Dollar Value averaging is more work than dollar-cost averaging. “It makes you do some math every month,” says John Markese, vice chairman of the American Association of Individual Investors. The advantage to dollar cost averaging is that you can set up an automatic payment plan from your checking account and forget about it.
Dollar Cost Averaging with Stocks
Most mutual funds were designed for dollar cost averaging. They make it easy for you and don’t charge a transaction fee for each purchase.
If you try dollar cost averaging stocks by buying them the traditional way, through brokers, you will have to manually make these purchases. That’s fine if you want to Dollar Value Average, but one of the benefits of Dollar Cost Averaging is automating the process.
There are many stocks you can buy direct, without a broker. They allow you to automatically purchase shares on an automated basis and reinvest your dividends. Stocks like Bank of America (BAC) and ExxonMobil (XOM) allow you to buy direct with no fees. A great place to start is Computershare.
Dollar cost averaging is a great way to invest in a mutual fund, diversify your portfolio, limit your risk and put your investing on automatic pilot.