Does Dollar Cost Averaging Work?
, on September 3, 2007
In my post about beating the S&P 500, I mentioned regular contributions as a factor that helped me. Over the weekend, I examined precisely how regular contributions helped. This led me to the subject of Dollar Cost Averaging (DCA), which until recently I thought was the same as regular contributions. They are not!
Dollar Cost Averaging versus Regular Contributions
DCA and regular contributions are similar in a sense that an amount of money is added to an investment portfolio on a regular basis. However, with DCA it is an intentional act of investing only a small part of a lump sum; whereas there is no lump sum involved with regular contributions.
Dollar Cost Averaging does not work!
Based on my research, DCA — at least the way that brokers try to sell it — is just a gimmick to get nervous investors to take the plunge. DCA actually does not work all that well and only works if the market is volatile or trending down. However, the market has been trending up as long as it has been in existence. Because of this upward trend, you almost always come out ahead investing the entire lump sum at the beginning.
This is the chart from “Introduction to CAGR,” showing S&P performance for the past 30 years.
DCA Scenarios Review
Take a look at the scenarios below.
- If I invested $10,000 in 1978, I would have $159,138. A lot more money than using dollar cost averaging, because the market was trending up and my money has a lot more time to grow.
- If I invested $10,000 in 2000 before the market went down, I would have only $9,653 in 2007. However, I would come out ahead if I use dollar cost averaging and spread my contributions weekly, monthly, or even yearly.
However, Regular Contributions Work
So in my case where I contributed to my 401k twice a month, regular contributions really did help me between 2000 and 2007. Regular contributions (not DCA) has many merits:
- More realistic way to save and invest, since most investors do not have lump sum
- When the process is automated — e.g., 401k contributions or automatic investment plan — regular contributions requires very little discipline and effort
- Works well in down or volatile markets
- Help ease fear for nervous investors
Here are some more about dollar cost averaging:
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