My advisor recommended this strategy to me and it took my by surprise that he suggested that I buy when the market is both up and down. What are the benefits to this method?
I agree with Eve’s comments about dollar cost averaging taking much of the emotion out of the investment decision making process. One thing I would add is that dollar cost averaging also encourages investors to be consistent and diligent in their approach to saving and investing. Consistent investors find far greater levels of success in achieving their goals.
Dear Gerrit, Dollar cost averaging is beneficial since it takes "market timing" out of the equation. Studies show individual investors who try to "market time" (buy low, sell high) inevitably end up doing the opposite. When individuals typically buy high (during periods of enthusiasm) and sell low (during periods of anxiety), their performance suffers over time. I believe it's not possible to forecast market or investment movements very accurately. Dollar cost averaging is the smarter way to invest in unpredictable markets.
I think dollar-cost averaging (DCA from now on) can be a wonderful strategy. If you think about it - this is exactly how most of us accumulate wealth! Think about it - every two weeks, or every month (depending upon how people get paid) - don't most people contribute to a 401(k)? And assuming they haved picked the asset allocation that best suits them - these contributions go into the portfolio when the market us UP - and when it is DOWN. And yet, somehow, over time - the account seems to grow... almost like magic!
Fact is - you don't know when the market will be up, and when it will be down. Some pundits on TV THINK they know - but the fact of the matter is that they DON'T. None of us do. If you check the stats on even the top-rated market guru's - they are usually right about 50% of the time. So is the coin in my pocket!
So - since you (and I) don't know when the market is going to be UP and when it is going to be DOWN - let's try a different strategy. Let's just invest over a period of time and let the market do the work for us.
The fundamentals of dollar-cost averaging work like this:
Suppose you invest the same amount of money - say, $500 - every month. You buy XYZ Mutual fund - a stock fund that fluctuates - that behaves just like the market did in 2011. It goes up - then goes way down, and then comes back up. When the market is going down - and you fearfully continue to invest the SAME amount of money - you actually BUY MORE individual shares of the mutual fund than you do when the market is at its peak. When the market approaches its tops - you actually buy FEWER of the higher-risk, overpriced shares (that you probably felt best about buying at the time).
In this manner - over time - you create a weighted average - MORE of the shares that you buy over time are the lower cost shares as opposed to the higher cost ones. FEWER of the shares that you buy over time are the higher cost shares - the ones that are less profitable and riskier (but were easier to buy because the market was "up" at the time).
In this manner -the average COST of the shares that YOU buy are actually lower than the average PRICE of the fund over time.
Generally, DCA is a wonderful way for average investors to build wealth over time.
If, on the other hand - you have a sizeable lump sum to invest - dollar cost averaging can "ease" worried investors into a market portfolio that they need to have in order to achieve their goals - sort of like slowly "easing" your way into a cold swimming pool on a hot day. Scientifically speaking, depending upon what the market does (remember - we don't KNOW what the market is going to do, despite the fact that virtually everyone THINKS they know), a DCA strategy with a lump sum may cause you to have MORE money - or LESS money than you would have otherwise had, had you instead just invested the money as a lump sum.
Unfortunately, that is the nature of investing... there is always the risk that you will be wrong. In this context, DCA is more of a behavior tool than a specific investment strategy, since no one knows for sure what the market will do next.
Jon Castle http://www.WealthGuards.com
I agree will all the advice so far and will add this. Once you have accumulated a little bit of wealth there is nothing wrong with moving that money to a safer investment and then dollar cost average your existing funds back into the market. Most people think that dollar cost averaging is for new money only but think about this; maybe you are super concerned about the volatility of the market but know you can not predict market direction with any real certainty so instead you move your money to safety and begin the process again. The average investor with a fairly strong risk tolerance should probably just rebalance their portfolios during peaks and troughs but a more risk adverse investor could be served very well by moving to safety and then dollar cost averaging their funds back into the market. It’s like easing into the poll instead of diving right in and losing your breath.
Gerrit, Edward Smith's advice is very solid. There are many other good comments here. Permit me to throw my two cents in as well.
If one looks at the most common form of dollar cost averaging, monthly contributions to a 401(k) plan, you will see that the markets are up one month and down the next month, then flat the next. Over the longer term these peaks and valleys “average out”.
When one is investing a without the constraints of a 401(k) plan, dollar cost averaging still makes sense. The trick is to be disciplined enough to stick to the plan. In investing, human nature can get the best of us. For example, we see an area of the market or a mutual fund that has done very well over the last year, and we want to jump in with both feet. Or, we see an area of the market that has done poorly so we don’t want to put our money there. The truth is we don’t know which area of the market or mutual fund is going to have the best performance this year or next year. The poor performer is at least just as likely to be the hot ticket next year as not, and today’s darling may be tomorrow’s dog.
There are numerous studies that show institutional investors, such as pension funds, fare better than individual investors. We believe that much of the difference in performance can be attributed to the fact that institutions tend to have long-term strategic asset allocations and have a more disciplined approach to investing.
We believe there are ways to reduce risk and enhance return by using a more dynamic dollar cost averaging process, but that requires ones eye to be on the markets on a day-by-day minute-by-minute basis. For example, a pension fund may commit to allocating $40 million to an S&P 500 index fund. They could decide to invest in four tranches over a one year period, a $10 million investment each quarter. They may accelerate a tranche if the S&P falls 10%, and accelerate the second payment if the S&P falls another 10%, and so forth. They are committed to being invested in the S&P 500 over the long-term, and understand that they are getting it cheaper when it is down. Not to confuse the matter, but this is a viable approach for a pension fund, advisor, or an active investor, and demonstrates the discipline necessary to stick to ones guns when the markets are choppy, and the pundits are predicting doom.
Rebalancing goes hand-in-hand with dollar cost averaging. Many investors ride an asset to the top and back down again, rather than rebalancing.
Dollar cost averaging and rebalancing the portfolio (to a strategic asset allocation) are ways to capture gains and reduce risk, these approaches lead to realizing gains and getting into relatively cheap areas of the market.
Gerrit, DCA makes sense if your investable funds are available on a regular basis (Monthly, Bi-Monthly) as in the case of salary deferrals for a 401-k, as pointed out. But if you have established a written financial plan - with clearly stated goals, objectives and time horizon.. and a lump sum is available to invest in that plan, I would argue its smarter to go in all at once .From the credible data that is available, we know that (historically) equities rise on about 70% of the trading days and decline on 30%... So going in monthly with a lump sum available is going against the odds. Best of luck! Evan
Investing can be habit forming and many habits are positive. Dollar cost averaging is one of those positive habits and this practice can be a solid way to understand budgeting and the opportunity cost of not saving enough. Something to be weary of though is that if you are averaging into commission investments, you might be paying sales charges on each transaction. Hopefully you have considered this and are finding options where you are getting the most bang for your investment plan.
Hi Gerritt, while the math of dollar-cost averaging is compelling, for me the biggest benefit of this method is simply that it is habit forming (in a good way!). We read reports year after year showing that as a nation we do a terrible job of saving for retirement through 401k plans, 403b plans and IRAs. So by using an "automatic" investing method like dollar-cost averaging, you can build your own savings habit and greatly increase the odds of maximizing your retirement readiness. And that's a good addiction for all of us!