Dollar cost averaging
Dollar cost averaging (DCA) is an investment strategy that aims to reduce the impact of volatility on large purchases of financial assets such as equities. Dollar cost averaging is also called the constant dollar plan (in the US), pound-cost averaging (in the UK), and, irrespective of currency, unit cost averaging, incremental trading, or the cost average effect.
By dividing the total sum to be invested in the market (e.g., $100,000) into equal amounts put into the market at regular intervals (e.g., $1,000 per week over 100 weeks), DCA seeks to reduce the risk of incurring a substantial loss resulting from investing the entire lump sum just before a fall in the market. Dollar cost averaging is not always the most profitable way to invest a large sum, but it is alleged to minimize downside risk. The technique is said to work in markets undergoing temporary declines because it exposes only part of the total sum to the decline. The technique is so called because of its potential for reducing the average cost of shares bought. As the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA possibly can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
However, there is also evidence against DCA. Finance journalist Dan Kadlec of Time summarized the relevant research in 2012, writing: "The superior long-term returns of lump sum investing [over DCA] have been acknowledged for more than 30 years." Similarly, decades of empirical research on DCA have found that it generally does not function as promoted and is usually a sub-optimal investment strategy.
Some investment advisors who acknowledge the sub-optimality of DCA nevertheless advocate it as a behavioral tool that makes it easier for some investors to start investing a lump sum. They contrast the relative benefits of DCA versus never investing the lump sum.
In dollar cost averaging, the investor decides on two parameters: the fixed amount of money to invest each time and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sum investing. One study found that the best time horizon when investing in the stock market in terms of balancing return and risk is 6 or 12 months.
Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested is
where is the final price of the investment and is the harmonic mean of the purchase prices. If the time between purchases is small compared to the investment period, then can be estimated by the harmonic mean of all the prices within the purchase period.
The pros and cons of DCA have long been a subject for debate among both commercial and academic specialists in investment strategies. While some financial advisors, such as Suze Orman, claim that DCA reduces exposure to certain forms of financial risk associated with making a single large purchase, others, such as Timothy Middleton, claim DCA is nothing more than a marketing gimmick and not a sound investment strategy. The financial costs and benefits of DCA have also been examined in many studies using real market data, typically revealing that the strategy does not deliver on its promises and is not an ideal investment strategy.
Recent research has highlighted the behavioural economic aspects of DCA, which allows investors to make a trade-off between the regret caused by not making the most of a rising market and that caused by investing into a falling market, which are known to be asymmetric. Middleton claims that DCA helps investors enter the market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount, the same amount one would have had one invested a lump sum.
The original popularized definition for dollar cost averaging came from Benjamin Graham's The Intelligent Investor. It was defined as "investing a set dollar amount in the same investment at fixed intervals over time." In recent years, however, a second definition for dollar cost averaging has arisen. Namely, that dollar cost averaging is a contrasting investment strategy to lump sum investing. Whereas lump sum invests a large amount of money today, dollar cost averaging spreads that lump sum over a period of time.
This confusion of terms is perpetuated by some articles (AARP, Motley Fool) and specifically noted by others (Vanguard, clarified in a later paper). The argued weakness of DCA arises in the context of having the option to invest a lump sum, but choosing to use DCA instead. If the market is expected to trend upward over time, DCA can conversely be expected to face a statistical headwind: the investor is choosing to invest at a future time rather than today, even though future prices are expected to be higher. But most individual investors, especially in the context of retirement investing, never face a choice between lump-sum investing and DCA investing with a significant amount of money. The disservice arises when these investors take the criticisms of DCA to mean that timing the market is better than continuously and automatically investing a portion of their income as they earn it. For example, stopping one's retirement investment contributions during a declining market on account of the argued weaknesses of DCA would indicate a misunderstanding of those arguments.
Continuous automatic investment is more like lump-sum investing in that the investor invests the funds as soon as they are available, in contrast to DCA where the investor withholds available funds from the market.
The weakness of DCA investing applies when considering the investment of a large lump sum; DCA would postpone investing most of that sum until later dates. Given that the historical market value of a balanced portfolio has increased over time, starting today tends to be better than waiting until tomorrow. However, for the average retirement investor's situation, where only small sums are available at any given time, the historical market trend would support a policy of continuous, automatic investing without regard to market direction.
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