What Is Dollar Cost Averaging and Is It a Good Idea?
Photo courtesy of Derek Gavey
Let’s say you have a big chunk of money that you’d like to invest, maybe a $3,000 tax refund. You have two basic options for how to do it:
- Invest all of the money all at once, or
- Invest just a little bit at a time.
That second approach is called dollar cost averaging. Instead of investing all $3,000 right away, maybe you invest $500 per month over a period of 6 months, or whatever dollar amount and interval works for you. You’ll still invest all of it eventually, it’s just done a little more slowly.
Keep in mind that this is different than setting up regular monthly contributions when you receive your paycheck. In that case you’re actually doing #1, it’s just that you have to wait for your paycheck each month to have the money available.
What I’m really talking about is situations where you have a bigger chunk of money that isn’t part of your regular monthly savings. Think things like:
- Tax refunds
- Bonuses
- Gift money
- Inheritance
In these kinds of situations, dollar cost averaging can be a good tool. But there are also some misconceptions about exactly how useful it is, so let’s take a look at the benefits and downsides so we can figure out whether it’s a good idea for you.
The benefits of dollar cost averaging
The benefits of dollar cost averaging are mostly psychological. By putting your money in slowly, you’re reducing the amount of risk you’re taking with that money until it’s all been invested. It’s reducing the chance that you’ll put your money in and immediately lose a big chunk of it, which can help reduce the amount of anxiety you have about investing it.
This is not a small thing. One of the most important things you can do as investor is to simply get started, and anything that helps you do that is a big plus.
And once you’ve gotten started, the next most important thing is to keep going and to stay consistent. If you’re nervous about investing all that money at once but you do it anyways, a market drop is likely to make you even more nervous and potentially scare you away from investing altogether.
The emotional part of investing is very real and definitely shouldn’t be ignored. A big part of being successful is understanding what kinds of risks you’re comfortable with and what kinds you aren’t. If dollar cost averaging helps you feel more comfortable, then it’s likely to help you be a better investor.
The downsides to dollar cost averaging
The thing that a lot of articles talking about dollar cost averaging get wrong is whether it provides better returns. It might, but it’s more likely that it won’t.
The research backs it up, showing that investing all of the money at once will give you better returns about 2/3 of the time. And it makes sense if you think about it too. The stock market generally provides better returns than a savings account. So by keeping some of that money in a savings account instead of putting it into the stock market, you’re missing out on some potential for better returns.
The other big downside is that by dollar cost averaging, you’re temporarily deviating from your investment plan. A big part of your investment plan is choosing your asset allocation, which is basically just choosing how much money you want to put into stocks vs. bonds vs. any other type of investment. If you were 100% sticking to your plan, any money you wanted to invest would immediately get invested according to your chosen asset allocation. After all, you chose it for a reason. But by dollar cost averaging, you’re temporarily keeping some of your money out of that plan, which means you’re temporarily straying from your chosen path.
One other downside: it adds a little bit of complication. You have to set up some kind of reminder or automatic contribution to make sure that the money all eventually gets invested, which certainly isn’t the most taxing thing in the world but does put more on your plate than simply investing it all right away.
None of these things should necessarily be deal breakers, but they’re worth knowing before you make a decision.
What should you do?
My personal approach in these kinds of situations is to invest all of the money all at once, basically for all the reasons mentioned in the “downsides” section. I like that it’s more closely sticking to my original plan, that it’s likely (though certainly not guaranteed) to work out better, and that it’s a little simpler. Plus, I really don’t even pay attention to what the stock market is doing, so the ups and downs don’t really bother me.
With that said, you should really take whichever approach feels right to you. If you’re nervous about it, don’t force yourself to invest it all at once just because the odds say you’ll be better off. You can learn to change your emotions towards investing over time, but forcefully pushing yourself off the cliff when you don’t feel ready usually isn’t a good idea.
I would think first and foremost about how you would feel if you invested the money all at once and the next day there was a 30% drop in the stock market. If that happened, would you hate yourself? Would you want to immediately pull that money out so you didn’t lose more?
If the answer is yes, then you should probably dollar cost average. If you wouldn’t really care, then maybe you should invest it all at once.
Either route will be good enough, so feel free to follow your gut.
This is an excellent description and I going to share.
One thought comes to my mind is “reverse dollar cost averaging”. When folks have “automatic withdrawals” from a diversified portfolio instead of “automatic deposits”.
It can have a “reverse” effect.
However, it goes back to your thought on the purpose of your investment plan.
TX! Chip
Well that’s interesting! Hadn’t ever thought of that one before – I guess cuz I’m always adding in vs taking out 🙂
Good point Chip. Generally, I don’t think that an automatic withdrawal plan is the most efficient way to do it. I think it’s better to start with a plan and review each year at least to see where you are and decide on the best way to move forward. Who knows, you may even be able to live a little larger than you thought!
I figure we do so much dollar cost averaging with our regular income, that any lump sum dollars need to be invested at once. Like you noted, a lump sum approach usually comes out ahead.
Well, technically your regular contributions that line up with your income are actually lump sum deposits, not dollar cost averaging. After all, you’re making the full contribution as soon as you have the money (your most recent paycheck). It’s not a huge deal, and those regular contributions are hugely important to growing your investments, but I think that small misconception is some of what leads people to believe that dollar cost averaging is a little more magical than it actually is.
I have a few investment accounts that I DCA into, but I think a great benefit is that for the average investor, it helps them capture the lows of the market without having to do too much research into it. Of course there will be times where the market high is bought, but buying the lows will, over a period of time, more than make up for it. It’s very much a good plan for someone who has no desire to run an analysis or determine intrinsic value.
I definitely agree that it can be a great tool, but it’s kind of a misconception that it should provide higher returns. If you’re buying into a market decline, then yes it will provide better returns than investing it all at once. But if you’re buying into a market rise, than investing all at once will be better. And since the market rises more often than it falls, the odds are that investing all of the money all at once will provide better returns. That doesn’t mean it’s always the right decision, but I don’t think people should dollar cost average and expect that it will give them better returns.
Thanks for a thorough explanation. I’d heard the term before, but wasn’t sure exactly what it was.
No problem!