DCA, also known as Dollar Cost Averaging, is a method of investing. It allows you not to be concerned with timing the market and enables you to grow your investments over the long-term.
The idea is that instead of investing a large sum of money at once, you break up your investment into smaller and regular deposits.
DCA is often used in the context of immediately receiving a large sum of money, and deciding what you are going to do with those funds. But in my case, I'm looking at investing regularly every month after we fund our long-term emergency fund. I think for most of us, that is the most common scenario where we would consider dollar cost averaging.
Later in the article, I'll talk about how dollar cost averaging is most effective when using regular income as part of an investment strategy.
For those of us who are not expert day traders, DCA frees us up from being overly concerned about timing the market. Instead, we can focus on trying to invest as much money as possible and optimizing our savings.
How Dollar Cost Averaging Works
Let's create a fictitious scenario to see how the numbers come out. For this example, we are going to look at one stock. In running these numbers, I found the AMP Dollar Cost Averaging calculator helpful. The below figures are from that calculator.
It is worth mentioning that when we don't have the option in investing a lump-sum when we start implementing DCA, the numbers will be different since the theory is you would be saving that same amount and then investing that money in one shot later. What this means is that the time at which you enter the market is going to be different, and you would have to save these funds in some kind of cash account. That option is problematic for a few reasons, which I will cover later in this article.
But in any case, understanding the basics of dollar cost averaging is beneficial.
Here are the details on the calculation:
- Let's assume we have $10,000 to invest. We have two options: either investing the full amount in one shot, or we can use dollar cost averaging to spread that investment over five months by investing $2,000/mo.
- We'll look at three different market situations: a falling market (but recovers), a market that is variable (but ends up landing about where it started) and a market that is rising.
Looking at the long-term trends of the overall stock market, I think we can assume things will generally go up over the long-term. But when we are looking at shorter time frames, we can expect the market to go up and down.
So let's take a look at what our $10,000 turns into over these five months.
In this market, we assume stocks are falling, but it will recover at about where we started.
- DCA: $13,000
- Lump Sum: $10,000
The market goes up and down, but ends up landing about where we started:
- DCA: $11,333
- Lump Sum: $10,000
The market continually rises and lands way above where it started.
- DCA: $12,819
- Lump Sum: $13,333
Thinking about These Returns
I know this is a simplistic breakdown. The chances of the falling and variable market scenarios ending around where they started are probably not likely.
But the idea is when we purchase a stock, mutual fund, or ETF at different price points, we reduce the risk in drastically miss-timing the market.
It is also interesting to note that with the rising market scenario, DCA doesn't return as much as the lump sum option. We are sacrificing some returns in that case, but both possibilities still did well.
Below I'll cover why this exact scenario is a bit flawed. If you do you have a lump-sum that you want to invest, you are better to get the funds into the market ASAP, especially if things are moving up (mathematically speaking).
You Might Already Be Doing DCA
If you have a 401k that you contribute to every month, you are already dollar cost averaging. Your 401k funds get auto-invested, regardless of what the market is doing.
When things go up or down, you are always buying the same amount (unless your contribution changes from an increase in pay or you change your contribution).
DCA is all about making smart financial moves and investing regularly. The more we can reduce the chance of making a stupid financial move, the better off we will be over the long-term.
Why I love Dollar Cost Averaging
I assume that over a long-periods of time, the stock market is going to increase in value. Some days it will go up, and other days it tanks.
But as far as investing with regular income, is there a better option outside of DCA?
If I leave that cash sitting in a savings account, chances are I will end up with less money over the long-term. If I try to time the market, the results could end up worse if I buy at the wrong time.
For me, DCA is all about getting as much money into the market as soon as possible, so I can start seeing my money grow. If we have our money sit around, we could end up missing fast moves in the market and not earn as much profit.
DCA Reduces Stress
I hate stress, especially when it comes to finances.
The beauty about dollar cost averaging is that when the market starts to dive, it actually can be a hidden blessing!
- It means I can buy more shares for the same amount of money
- The farther the stock market falls, the more shares I can accumulate
- When the market “hopefully” recovers, I will make more profit
- If the stock market continues to rise, my funds should go up more quickly, since I will have more shares
When I invest a large amount of money, any time the market goes down, I'm going to freak out and make sure that I'm not losing money from my initial investment
If the market goes below my entry point, financially depression will take over my mind like a weed, if I bought a large amount as a specific price point.
By mixing up my portfolio with different entry points, I know that I have shares where I will be making money and some that will be down at most points in time. As the market goes through different cycles, I'm less concerned about what the market is doing at any moment.
Dollar cost averaging calms my nerves and lets me focus on dumping as much money into the market as possible.
Implementing Dollar Cost Averaging with Vanguard
The easiest way to implement dollar cost averaging is to figure out a set amount you want to invest monthly.
If you want to set up your investments on autopilot, a great option is to invest in a Vanguard Mutual Fund. These funds usually have more substantial initial investment requirements, but once you meet them, you can set up automatic deposits. These deposits can be any amount, and they support fractional shares.
The fact that you can invest any amount into a Vanguard mutual fund and set up automatic deposits makes it easier to implement dollar cost averaging.
You could also go with the corresponding Vanguard ETF's, but you can't set up automatic deposits, and you have to purchase whole shares.
Vanguard Admiral Shares mutual funds are a great mutual fund option. The good news is that Vanguard recently lowered the initial investment required for these mutual funds from $10,000 to $3,000. This price point makes admiral shares more accessible, but you might need extra time to build up enough to meet their minimum investment.
There probably are just as good options out there. If you know of any others, I would love to hear about them.
Risks of Being on Autopilot
It's great to set up part of your investments with automatic deposits, but we shouldn't use that as an excuse not to be mindful of whether our allocation matches our risk tolerance.
Before you set things on autopilot, you need to think about how you will allocate your investments. And your risk tolerance will most likely change over time.
It will be a few months before I start to invest in the stock market heavily. I'm still not 100% sure what I will do, but I need to figure out how I want to allocate those funds before I dive into the market. The good news is that if I end up changing my allocation, I can redirect the auto deposits.
The more I can put my finances on autopilot and ensure I educate myself on what I want to do, the more likely I will stick to a general financial plan that pushes me towards my long-term goals.
When Not to Use Dollar Cost Averaging
Their report helped clarify something I read about, but had a hard time confirming: if you do get a large lump-sum, is DCA the best option?
Here is an excerpt from the Vanguard report:
On average, we find that an LSI (lump sum investment) approach has outperformed a DCA approach approximately two-thirds of the time
The report talks about if the market is going up, you are usually better getting into the market earlier, than trying to wait it out.
But they also point out that DCA still might be a good option even with LSI, depending on your risk tolerance.
…if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use.
I found this interesting because it would seem as though the same logic that works for DCA with regular monthly investing would also work when dealing with a lump-sum. But the math doesn't support that idea.
The report ends up differentiating the type of DCA we are talking about, and what they are addressing in their study.
Most popular commentary addresses DCA in terms of consistent investments made using current income—i.e., an employee transferring a portion of each paycheck into a retirement account. In that case, investable cash becomes available only in relatively small amounts over time, which makes DCA a prudent way to invest (and really the only sound alternative to accumulating that money in cash and then actively trying to time the market at some later point).
Their study dealt with investing $1,000,000 and seeing how it would perform over 10-years with LSI vs. DCA from 1926 to 2011. Their final results found that 2/3 of the time, LSI outperformed DCA by 2.3%. That came to an end balance of $2,395,824 vs. $2,450,264.
Notice that both scenarios did very well. In my opinion, even if I received a lump-sum amount, I will most likely implement DCA for more piece of mind. The amount of stress I save, even when risking profit, is worth the cost.
But I can't tell you what is the best option in regards to investing a lump-sum of cash. Only you can make that decision.
So What's the Bottom Line?
As far as investing is concerned, here are the main points:
- When investing using regular income, DCA is the best way to go.
- If you receive a large lump sum that you want to invest, mathematically speaking, you are better off getting it into the market ASAP, especially during upward trends. With that said, you still might decide to go with DCA. In most cases, you won't miss out on too much profit.
- Dollar cost averaging can reduce risk in inadvertently entering the market right before a significant downturn. It also can make things less stressful when things go down, as we realize we are getting more for the same amount of money.
- It is challenging to time the market. Over long periods, the stock market has grown.
- If you create a strategy, stick to it and avoid reacting to the market.
Vanguarmutual funds allow us to setupautomatic deposits, which simplifies managing our money.
Investing doesn't have to be complicated. By making it simple, we are more likely to stick to a plan and see our money grow over time. We will most likely encounter bull markets and recessions, but if we are actively investing, we can put ourselves in a better position to see our money grow.
What do you think about DCA? Have you set up automatic deposits into your investment accounts as part of your budget?