Dollar-Cost Averaging (DCA)
The question that everyone is asking is “Does it really work?”
The idea behind dollar-cost averaging makes sense: buy more shares when the price is cheap and less when the price is high with the hope of lowering your average cost per share. This is compared to the idea behind lump sum investing: the longer you have your money in the market, the more money you will make. This strategy works best if you have the money available as a lump sum. Lump sum investing is probably the best investment strategy because historically the market has risen substantially over time.
For those of us who do not have a lump sum available to invest (like me…since I just started a job), dollar cost averaging, while maybe not the greatest strategy for everyone, significantly beats leaving the money in a money market or checking account until you get to a “lump sum.” It also is important to make the monthly investment without commissions, be it a mutual fund or an ETF or a stock through a dividend reinvestment plan. Investing $50 a month into a stock with $8.95/trade cost would cause you to effectively lose greater than 17% of that investment each month to commissions.
Another strategy: By making a single lump sum into a dividend paying stock (especially the ones that have historically increased dividends annually), one would effectively get the benefit of an initial lump sum strategy AND would get the dividends reinvested for free using a dollar-cost averaging model. I’ve done this with my General Electric DRIP. I bought it back in 2004 with the proceeds from a mutual fund that closed. The initial share price was around $34. I’ve had the dividends automatically reinvested and have since made additional lump sum investments. Unfortunately, the stock dropped to less than $10 with the financial crisis (and the dividend was cut). The stock has been slowly making its way back to the $20 range and has begun raising dividends again. I’m in the stock for the long term so short term price drops like this actually benefit me because my dividends and cash investments buy more. I’ve effectively been able to decrease my per share cost to $28. I’ve substantially decreased the price at which I’d break even.
In another post, I’ve written about the Google Docs spreadsheets that I’ve made available as public templates. There are two available, one that provides the framework for tracking a dividend reinvestment plan and another that is solely for dollar-cost averaging. These are available here: Google Docs Investment Templates
The Internet has a plethora of dollar-cost averaging information. I’ve collected my favorite articles here:
1) Does Dollar-Cost Averaging Work? Provides a comparison of lump sum vs. dollar cost averaging with a hypothetical investment into an S&P 500 index fund.
2) About.com’s Investing Basics page on Dollar-Cost Averaging A great place to go for a quick summary.
3) Cashmoneylife.com’s: Pros and Cons of Dollar Cost Averaging Another excellent summary article.
4) State Farm Mutual Funds: What is Dollar-Cost Averaging? Has a chart that provides a hypothetical illustration of dollar-cost averaging. Again, this is described in relation to allowing the average person to make manageable contributions for his retirement. No comparisons to lump sum investing with this assumption.
5) The Motley Fool’s: The Downside of Dollar-Cost Averaging Describes ways that dollar-cost averaging would be beneficial and ways in which it is less than optimal.
6) USA Today article from 2006: Dollar-cost averaging’s not all it’s cracked up to be A great article that clarifies many of the points that I’ve made above. Also, brings up a variant of dollar-cost averaging, called value averaging. This is a more active approach to the dollar-cost averaging strategy where one aims to increase the value of the portfolio by a consistent amount each month. If the account gains a lot in value, then less is added, but, if it falls substantially, enough extra is added to make up for the drop. The article also talks about the value of increasing the contribution by 5% every year.
7) DRiP Investing Resource Center: http://dripinvesting.org/ Includes a forum to discuss DRIP investments.
The articles below are more scientific and technical:
7) Efficient Frontier’s: Do Not Dollar-Cost-Average for More than Twelve Months
8 ) Financial Services Review: Nobody gains from dollar cost averaging analytical, numerical and empirical results Volume 2, Issue 1, 1992-1993, Pages 51-61.