Dollar cost averaging, or DCA, is an investment strategy in which recurring, incremental investments are made on a recurring basis. Compare this to lump sum investing in which the total investment capital, whether it’s for a stock, exchange-traded fund (ETF), or other security is employed all at once.
The rationale behind dollar cost averaging is that by spreading the purchase over a longer period, fluctuations in share prices can be avoided, as opposed to trying to time the market for the perfect time to buy. Many financial pundits consider this to be a sound strategy, but is DCA investing overrated? Maybe.
Price fluctuations are inherent to the nature of stocks, ETFs and other types of publicly traded securities. Ideally, a capital investment is made when the acquisition price is lowest, in order to maximize gains over time. However, timing the market is very difficult. To counter this, some investors will purchase small blocks of a security over time to benefit from price drops.
The strategy is more commonly employed than people may realize. Investments in 401(k) plans are a classic example of dollar cost averaging. Securities purchases are made each pay period, with an equal amount of money. In this way, large blocks are gradually acquired. This manages the price risk of investing at the “wrong” time, which in turn serves as a potential hedge against market volatility.
Consider a scenario in which an individual gets a windfall of $25,000. Deciding to invest the money, rather than spend it on something frivolous, the person is faced with a couple of choices. They could invest the entire $25,000 all at once, or they could divide the $25,000 into 12 equal increments and feed the money into the investment gradually over the course of a year.
Should the price of the stock drop immediately after investing the lump sum, the investor will likely experience a setback. With dollar cost averaging, if the price drops right after the initial purchase, the investor can take advantage of the lower price the following month. Moreover, should the decline continue, the investor can get even more shares at that lower price over the course of the year.
The investment may eventually begin to pay off — assuming the fundamentals of the company in which the investments are made are sound and the company’s stock ultimately appreciates in value.
Investors with a low risk tolerance may find their investment preferences met by employing a DCA strategy. Investing a lump sum, only to see the value of the investment immediately decline, can be profoundly unsettling. The reaction of many people would be to sell out of the investment and buy into something else. The problem with that, however, is that panic selling usually opens the investor to timing risk.
Rather than trying to time the market, dollar cost averaging increases the investor’s time in the market, which can yield a more favorable result. As an investment strategy, market timing fails more often than it succeeds.
Investors with more experience in the market and the cash on hand may prefer lump sum investments, as they may feel they have a better handle on the ebbs and flows of the broader markets.
With DCA, there is often no need to watch the market closely, as the strategy functions automatically. DCA also mitigates the potential for impulse investing as it relieves the investor of questioning whether to buy now, wait for earnings reports or hold out for a potential market dip.
The bottom line is that investors concerned about market volatility and the risks it presents, or those who are prone to make emotional investment decisions, may likely be better served by DCA.
With all the above said, history does tend to favor lump sum investing, albeit by a very small margin. A study conducted by Vanguard, as reported by Forbes, found that lump sum investing beats dollar cost averaging about 2/3 of the time over a 10-year period.
Moreover, given our scenario above of an individual gaining a $25,000 windfall, they would be holding on to much of that money in the form of cash for a longer period, incurring opportunity losses. After all, the entire windfall could have been put to work sooner, potentially earning more.
Yes, risk can potentially be reduced with DCA, but given that risk and reward go hand in hand when it comes to investing, avoiding risk can also mean foregoing reward. This isn’t true in the case of a 401(k) plan, because the investor is getting the cash gradually, rather than all at once. Further, the money is being put to work as it is earned.
Another downside of dollar cost averaging is increased exposure to brokerage fees. In some cases, each new purchase could trigger another round of transaction costs, which could outpace potential returns.
Value averaging requires an investor to set a target growth rate for their portfolio and add to it as required to maintain the prescribed rate of growth. This necessitates close monitoring, so that the investment contribution corresponds to fluctuations.
If the value of the portfolio increases, the contribution is diminished. If the value of the portfolio drops, a correspondingly higher contribution is made. In this way, more shares are purchased when prices are lower and fewer purchases are made when prices are higher. Generally speaking, value averaging does tend to outperform dollar cost averaging, although again, it requires more effort on the part of the investor.
“Buying the dip” is a strategy wherein purchases are made when the market has declined below a pre-determined level. The challenge here is setting the most favorable buy threshold. Set too low, purchases may never occur. Set too high, the investor risks making a sizable purchase just before the price drops further. Another potential concern associated with buying the dip is the amount of time investors must spend analyzing market trends.
Meanwhile, an incremental investment is made periodically with DCA, regardless of the degree of fluctuation. Buying the dip requires constantly running the numbers to determine if the time is right to buy. With that said, if one is intent on pursuing the dip strategy, its best use demands a long-term approach. Buying the dip for short-term trades generally loses out to passive buy-and-hold investing.
Regardless of the acquisition strategy an investor chooses to pursue, maintaining portfolio diversification can serve as a hedge against market volatility. Traditional asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, these private market investments tend to be less correlated with public equities, and thus offer potential for diversification. This can help protect a portfolio during periods of extreme market downturns.
Alternative assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors. Learn more about the ways Yieldstreet can help diversify and grow portfolios.
Investors should consider their tolerance for risk and their overall investment goals to appropriately answer this question for themselves. It is also wise to take their investing experience and the amount of cash they have on hand to fund investments into consideration.
Studies have shown that lump sum investing (given the cash to pursue it) can outperform dollar cost averaging. Value averaging also holds the potential to outperform dollar cost averaging, as does buying the dips — if the investor has a steady stream of investible funds. However, these methods require an investor to engage in constant monitoring and have a significant tolerance for risk.
Dollar cost averaging, while potentially less lucrative, helps mitigate those concerns, even while often delivering comparable — if slightly lower — returns. According to Forbes, because it is impossible to predict future market drops, dollar cost averaging can offer solid returns while potentially reducing the risk an investor experiences in the 33.33% of cases in which lump sum investing falters by comparison to DCA.
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