Dollar Cost Averaging

The Logic behind DCA

Frequent, regular purchases insure that you do not make a large purchase at the worst possible time – at the high point. On the flip side, no one can predict the bottom, so timing your purchase isn’t a realistic option.  Buying into the market on a regular, ideally automated, basis will ensure that you pay a nice average price for the equities you purchase.  If you were to chart your purchases on a line graph for a year, you would see that the more frequent the purchase, the smoother the line.  Additionally, in terms of number of days in the year, there are more down days than up days, so making frequent purchases increases the odds that you will get a lower average price.  Although there are exceptional years, the time weighted return of your cost is very often going to be lower than your fair market value at the end of the year.  An exception to the beneficial effects of dollar cost averaging would be a year that was significantly higher in the beginning with a considerable decline at the end.  That scenario is infrequent, however, and it should not dissuade you as an investor from employing a DCA strategy. 

Human Behavior

Behavioral finance is a big topic; it doesn’t get the attention it deserves. The effectiveness of the DCA strategy can be compared to the way we’re more likely to spend 20 one-dollar bills than a single 20-dollar bill. We are also more likely to follow through with investing in small, regular amounts as opposed to saving up a large sum with the good intention of investing it. In my work, I continually see people be amazed at how small dollars invested regularly can add up over time.  Automatically investing immediately before you have a chance to spend the money on something else is ideal.  There are always other demands on our money, and so employing a disciplined dollar cost averaging strategy is the best way to ensure your nest egg thrives. Most likely you won’t even miss the money or noticeably reduce your standard of living.          

Practicality

Investors should do what is practical and easy because if it isn’t simple, it may not be carried out.  Financial institutions offer automated options that can make these contributions effortless. For example, if you are paid on the 1^st and 15^th days of the month, you could set up a DCA program with your financial institution that coincides with those dates.  Although ideal, daily is probably not systematically practical for most.

One important thing to note:  If you already have a large sum to invest, you should not spread the purchases out over a significantly long period of time.  You can phase it in over several months, but don’t delay it for too long.  Dollar cost averaging is best served when you are investing from an income stream.  Delaying a purchase for a year or years could have a negative effect on your return, especially with interest rates as low as they are today. Besides, it also gives you too much time to think about where else you could spend that money you had planned to invest.