One of the biggest fears of any new or seasoned investor is losing money. This fear actually inhibits some people from ever investing at all, and it might also lead to selling preemptively or opting for a lower risk investment option time and again. To minimize the fear of losing money, some investors choose to a risk-reduction strategy, such as Dollar-Cost Averaging (DCA).
Research in the field of psychology indicates pain of losses is more severe than the joy of gains for investors, so risk-averse investors may prefer to dollar cost average simply to minimize the potential regret of not doing so and seeing markets decline shortly thereafter. However, the majority of academic research has shown that while dollar cost averaging may help to manage the perception of risk, on average it just reduces returns (and therefore is inferior to lump-sum investing). Still, the popularity of DCA remains high among practitioners and the investing public.
What is DCA?
DCA is an investment tactic in which a fixed amount of money is invested at regular intervals. The intended goal of DCA is to provide the investor with a lower average cost of shares over time. Since the investment amount will be the same at each interval, the idea is that more shares will be purchased when the price is low, while fewer will be purchased when the price is more expensive. There are two forms of DCA depending on the source of the funds being invested. The first is when you are building your investment portfolio by adding to it from your current cashflow. This would mean investing a set dollar amount each month from your income. The second is when you have a large amount of cash and decide to invest it slowly over time.
Those who support the use of DCA claim that it can provide a lower average purchase price for a risky asset, proposing that purchases of assets (that are higher risk) with DCA when prices are declining will provide better returns than lump-sum investing. As you will see, this assumption of a lower average purchase price does not necessarily hold up in real life.
What are the Proposed Benefits of DCA?
By only investing a portion of your lump sum, price drops will not impact your portfolio as heavily had you invested a larger portion or your entire sum. Dollar-cost averaging is meant to mitigate the risks involved in lump-sum investing through which an investor could face major losses if the market crashes or prices fall drastically. Risk-aversive individuals may, therefore, prefer to use DCA.
Market fluctuations and losses can greatly affect an individual’s emotional well-being. Further, emotional responses to these ebbs and flows, such as overconfidence or panic, can affect future investment decisions. Since only part of a sum is exposed to the market, losses may not be as drastic. Therefore, many individuals may experience a duller emotional reaction than if all of their sums were to be affected, decreasing the likelihood of their making emotionally-driven investment decisions in the future.
As such, DCA may be good option for those looking to minimize the impact of emotion on their investment choices.
What are the Critiques of DCA?
Missing Out On Gains
When employing dollar-cost averaging, portions of your money sit uninvested. The main argument against DCA is that these portions are not given the chance to accumulate any return at all. As a result, some investors and financial professionals may prefer another strategy such as lump-sum investing, which exposes a larger portion of your funds to the market.
Lump-Sum Investing vs. DCA
In lump-sum investing (LSI), a larger portion of your money is given the chance to make gains sooner rather than later. However, investing a significant portion of your money also means that you may experience more pronounced losses in a vacuum. Over time, however, you can make up for these losses. This long-term thinking also supports the idea behind dollar-cost averaging.
What does the research say?
Vanguard's 2012 Study of Dollar-Cost Averaging
In 2012, Vanguard published a study comparing the historical performance of DCA and LSI. The study used stock and bond market data from 1926 through 2011 in the United States, United Kin, included a range of asset allocations from 100% stock to 100% fixed income, and also looked at various period of time for DCA. Each trial was conducted using a 10-year investment timeframe. For a more detailed explanation of the study's methodology please reference Vanguard's published findings.
Summary of Findings
Despite the use of three international markets and various time periods, the results were surprisingly consistent. When using a 12-month DCA period and invested in a 60% stock and 40% fixed income portfolio, LSI outperformed DCA approximately 2/3 of the time in all three countries. What is even more striking is these numbers do not change drastically when the asset allocation shifts.
Vanguard then calculated the outcomes using 6-, 18-, 24-, 30- and 36- month DCA periods to see how the length of DCA effects the outcome. In general, they found that longer DCA periods increased the likelihood LSI would outperform DCA. In US markets, a LSI strategy outperformed a 36-month DCA strategy 90% of the time. Vanguard found that, using a portfolio with a 60% stock and 40% fixed income allocation invested over 10 years, the LSI strategy produced a final portfolio value 2.3% greater than a 12-month DCA strategy on average. Please note these are average results using historical data, and future returns could vary significantly depending on future market conditions.
But DCA is a Risk Reduction Strategy, Right?
Proponents of DCA tout its ability to mitigate the risk of a market decline over time. By holding the cash position over time, you are reducing exposure to market related risk. For a fair comparison of LSI and DCA, we need to compare their risk-adjusted returns. If DCA is an effective risk mitigation strategy, it should outperform LSI on a risk-adjusted basis. Instead, Vanguard found was "LSI has provided better returns and better risk-adjusted returns on average."
When to Consider Using DCA
Investors might choose to employ dollar-cost averaging for a variety of different reasons, including for investments that are historically more volatile. DCA is also a way to potentially regulate emotional responses. Dollar-cost averaging might be used in the following circumstances:
- Individuals who want to invest, but fear a sudden market decline
- To prevent paralysis by analysis (market timing)
- Individuals who do not have the funds for a lump-sum investment
The alleged benefit of dollar-cost averaging is that it encompasses the unpredictability of the market yet intends to lower the cost of your shares as a result. What Vanguard's research found, however, is that Lump-Sum Investing is generally a better strategy for better returns and risk-adjusted returns. If investing using LSI feels too risky, it may be prudent to reassess your portfolio's asset allocation to better match your risk tolerance. When choosing how to invest, it is wise to seek the counsel of a financial advisor who can help you make the best choice for your circumstances and future goals.