Dollar cost averaging

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Dollar cost averaging (DCA) [1] is the technique of dividing an available investment lump sum into equal parts, and then periodically investing each part. Dollar-cost averaging is proposed as an alternative to lump sum investing (LSI), which is to make the entire investment immediately.

For any sequence of constant-dollar purchases[2] of an asset whose price fluctuates, more shares will be purchased when prices are lower than when prices are high. [3] As a result, the average cost per share will be lower than the average price per share over the same period. This is sometimes called Dollar-Cost Averaging, and is an argument used to persuade investors to make systematic, periodic investments regardless of market prices.

The term Dollar-Cost Averaging is also used to describe similar investment concepts such as periodic automatic investment (almost universally utilized by individual investors to fund retirement accounts out of earned income).

Variants on the idea of DCA include "reverse dollar cost averaging" which pertains to periodic automatic withdrawals made during retirement. [4] Also, Value Averaging closely resembles dollar cost averaging but differs in that the investor selects a target growth rate or amount on his or her asset base or portfolio each period, and then adjusts the next period's contribution according to the relative gain or shortfall made on the original asset base. [5]


Dollar cost averaging versus lump sum

When you are ready to invest money, a common question is whether you should invest it as a lump sum or Dollar Cost Average (DCA) by splitting your investment across several payments. The answer depends on your psychology.

In most cases, you are moving your money from cash (or the equivalent, a low-yielding money market) to some mix of stocks and bonds. The expected value of both stocks and bonds are higher than cash. However, their volatility is higher as well. The risk is that just after making your investment, the market could crash, causing you to feel bad that you invested when you did.

Of course, according to Bogleheads Investment Philosophy, you should only be investing in the first place into a diversified asset allocation. Also, you should only be holding volatile funds like stocks and bonds if your investing horizon is long enough to ride out their volatility.

For a completely rational investor, lump sum investing will always produce a higher expected return, because it immediately moves your funds from asset classes with lower expected returns to ones with higher expected returns. Note that higher expected returns do not guarantee that your actual returns will be higher. According to an investopedia article, [6] studies indicate that lump sum investing has produced higher returns 66% of the time.

Some investors have the goal, not of maximizing their expected returns, but of minimizing their potential regret. For those investors, dollar cost averaging is superior because it reduces the chances of investing just prior to a market drop. If you instead decide to invest 1/6th of the money each month for 6 months, you will reduce the chance of buying just before a crash. Instead, as the price fluctuates each month, you will buy more shares when the price is low and less when it is high.

Many new investors are more interested in minimizing their potential regret, and it's important that an ill-timed market drop not scare them off from investing in the future. Many experienced investors are more interested in maximizing their expected returns. You can also decide to split the difference, where you invest half immediately and the other half over 6 or so months.

Costs

Most no-load mutual funds allow small, regular investments with no fees. However, most investors pay a commission to purchase a load-fund or an ETF. Depending on the size of the commission and the investment, DCAing into a load-fund or an ETF could be far more expensive than purchasing as a lump sum. For ETFs, the bid/ask spread is the same between DCA and lump sum.

Automatic investment

Most investors make regular contributions through their 401(k) plans or by having a set amount auto-deducted from their bank account into an IRA or taxable account. When this money is automatically invested, it has the same benefit of dollar cost averaging that you buy more shares when prices are low and less when they are high. However, this form of investing is not dollar cost averaging. It is called periodic investing. The difference is that periodic investing is maximizing expected return, because you are investing the money as soon as you have it. DCA applies when you have the money to invest, but delay doing so.

Switching to a more conservative portfolio

Some investors who are new to a Bogleheads Investment Philosophy may find their portfolios contain too much equity. Even worse, some investors have a large portion of their net worth held in a single stock, such as through an employee purchase plan. They generally want to sell some of their equities and buy bonds. In these cases where an investor wants to move from high risk and volatility assets to lower risk and volatility assets, a lump sum transaction makes more sense than DCA. That's because lump sum both immediately moves to the expected return and volatility the investor wants, while also minimizing potential regret.

Reverse dollar cost averaging

Investors who regularly add to their investment portfolios with periodic investing purchase more shares when prices are low and less shares when prices are high. Author Henry K. Hebeler [7] points out that investors periodically distributing retirement income from their portfolios experience the reverse action, redeeming more shares when prices are low and less shares when prices are high. Hebeler terms this process, "reverse dollar cost averaging" with results that should, on average, reduce expected returns. Examining rolling 20 year investment periods from 1927 to 1995 for a portfolio consisting of 50% large cap stocks (S&P 500); 40% long term corporate bonds; and 10% treasury bills, with expense loadings of 1.50% for stocks; 0.50% for bonds; and 0.30% for cash), Hebeler provides average real returns for four scenarios: the portfolio; the accumulating investor; the distributing investor; as well as the results of 80% percentile returns (reflecting desires for portfolio survivability for retirement distributions). One should also note that indexing the portfolios would add 0.70% to each portfolio's returns simply due to reduced costs. [8]

Average Real Returns (rolling 20 years) 1927-1995
Portfolio return
50% stock/40% bond/10% cash
Accumulating investor Distributing investor
Portfolio 2.9% 3.2% 2.6%
80 percentile 1.2% 0.8% 0.3%

See also

References

  1. In the UK this technique is called Pound cost averaging, see The Benefits of Pound Cost Averaging, Morningstar
  2. Equal parts means that the amount (dollars) is constant, hence the term "constant-dollar".
  3. Dollar cost averaging definition, investopedia
  4. Reverse Dollar Cost Averaging, Henry K. Hebeler 1/2/01.
  5. Value averaging definition, investopedia
  6. Fight The Good Dollar-Cost Averaging Fight
  7. Henry K. Hebeler Getting Started in A Financially Secure Retirement; ISBN 978-0470117781
  8. Reverse Dollar Cost Averaging, Henry K. Hebeler 1/2/01.

External links

Bibliography