Does Dollar Cost Averaging Work?
By Pinyo • Sep 3rd, 2007 • Category: InvestingIn 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 a fixed 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 may be just a gimmick to get nervous investors to take the plunge, because it does not work. DCA 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.
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.
Regular contributions helped
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 contribution 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:
- The costly myth of dollar-cost averaging, MSN Money
- Does Dollar Cost Averaging Work?, MoneyChimp
- Dollar-Cost Averaging: An Excellent Investment or a Big Surprise?, The Motley Fool
- Dollar Cost Averaging: Does It Work In The Real World? How Can I Use It Easily For My Own Investments?, The Simple Dollar
- Dollar Cost Averaging: A Poor Way To Reduce Risk?, My Money Blog
- Does Dollar-cost-averaging work?, Index Fund Fan
This article was featured in:
- The 117th Carnival of Personal Finance hosted by KMull.com. For more information please visit the Carnival of Personal Finance.
All posts by Pinyo
Thanks for the clarification. I thought the two were the same myself.
Concur. You might be interested in Edleson’s Value Averaging. I consider DCA to be “accidental” averaging, whereas VA is “intentional” averaging.
Many of the criticism of DCA are misguided. Comparisons with lump sum investments made up front make the faulty assumption that that this option is open to many small investors. If your investable money comes from a salary it will come in small amounts. Then you have two options:
(a) invest small&fixed amounts regularly (regardless of market conditions) (my version of CDA)
(b) accumulate a larger sum and try to pick the time to spend it when the market is right
I suspect if many of the DCA critics looked at the performance of these two strategies DCA would look more sensible
regards, rick
Rick - Welcome to Moolanomy. I believe we agree more than disagree here.
What you called “my version of CDA” is what I called “Regular contributions”. The distinction I made is that DCA (or CDA) meant you already had a big lump sum - e.g., inheritance and you purposefully invest only a small portion of it. In this case, DCA does not make sense because more likely than not, investing that entire lump sum upfront will produce better result.
As far as point B, I would never recommend that to anyone because nobody can accurately predict the market.
I agree with Rick above. There’s another flaw in the criticisms I’ve seen of DCA: they declare that lump sum investments are “better” simpley because they have larger returns. But this assumes that the way to compare portfolios is just the return, instead of risk-adjusted returns. The argument that lump-sum is better than DCA because it has a higher return is no better than the argument that DCA is better than lump sum because it has lower risk.
In the end, I do think the whole issue is a distraction. The two important principles should be:
1. Invest incoming cash flows as soon as they arrive, according to a clear, careful budget plan.
2. Divide your investments between stocks and bonds to reflect your risk tolerance.
When you apply these principles, you invest lump-sum when you receive lump-sums and you DCA when you receive smaller regular payments, and you manage risk by maintaining a constant asset allocation, not by holding money back.
@Luis - welcome to Moolanomy. I like your comment — very well said. I especially like the two principles and the subsequent summary. That’s exactly how I would do it as well. Thank you for contributing to the conversation.
I think if I had a big sum to invest, I’d do it all at once. But unless I do, I’ll probably do some form of dollar-cost-averaging. As opposed to buying X shares every time…