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Pros and Cons of Dollar Cost Averaging

by Ryan Guina

Dollar-cost averaging is a common investment strategy where you invest the same amount of money at set intervals. This takes the guesswork out of market timing and you don’t need to worry about trying to “time the market.”

Because the amount you invest remains constant, you are able to buy more shares when the price is low and fewer shares at a higher price. The goal is to buy more shares at a lower average cost per share over time.

This sounds like a great way to invest, and it can be. But there are times when there are better ways of investing than dollar cost averaging. For example, many experts believe that lump sum investing can result in better returns than investing a little bit over time. The idea behind lump sum investing is that the longer you have your money in the market, the more money you will make. Lump sum investing works best if you have a large amount of money to invest at one time.

Lump sum investing vs. dollar cost averaging. Here is an online tool that calculates actual returns using dollar cost averaging vs. investing in a lump sum. If you play with the tool for a few minutes, you will find examples where lump sum investing wins out, and examples when dollar cost averaging brings better returns.

Even though lump sum investing can result in better returns over the long run, let’s look at an example of dollar cost averaging and why it makes sense to invest that way.

Dollar Cost Averaging Example

Let’s take a look at using dollar cost averaging to max out a Roth IRA. The max you can invest in a Roth IRA in 2008 is $5,000. Many people don’t have $5,000 to put down at once, but they may be able to break it down into monthly payments.

Here is how dollar cost averaging would look if you broke down an IRA investment over 12 months (The numbers represent a fictional fund):

Investment date Amount invested Price per share # Shares purchased
January $416.66 $33.21 12.55
February $416.66 $35.70 11.67
March $416.66 $34.83 11.96
April $416.66 $32.10 12.98
May $416.66 $33.71 12.36
June $416.66 $35.08 11.88
July $416.66 $29.04 14.35
August $416.66 $28.17 14.79
September $416.66 $27.92 14.92
October $416.66 $25.83 16.13
November $416.66 $26.42 15.77
December $416.66 $28.18 14.79
Total $4999.92 $30.46 avg. 164.15 shares owned

In this example, you can see that as the price per share goes up you can buy fewer shares, and as the price per share goes down you buy more shares. Note that the average share price is $30.46, which is less than the share price during January. In this example, dollar cost averaging comes out ahead of investing in a lump sum, but it could very well come out with the opposite result.

Pros of Dollar Cost Averaging

Affordability. Dollar cost averaging is more affordable and allows people to treat investing like paying a bill. It is difficult for most people to invest a $5,000 lump sum to max out a Roth IRA or Traditional IRA. However, many people may be able to afford a monthly installment of $416.66, which will put them on pace to max out their IRA for the year.

A similar example is investing in a 401(k) plan, which is deducted directly from your paycheck. Even if you could afford to invest the $15,500 limit at the beginning of the year from your cash savings, your paycheck wouldn’t be large enough to cover that. Most people also rely upon their paycheck to pay bills throughout the month. A 401(k) plan forces the participant to use dollar cost averaging.

Convenience. It is easy to set up dollar cost averaging as a monthly payment and incorporate it into your budget.

Cons of Dollar Cost Averaging

Lump sum investing can result in better returns. Lump sum investing can often result in better returns because you have your money in the market longer. This is based on the idea that the longer you have your money in the market, the better your returns are over the long run.

More fees. Dollar cost averaging also means making more transactions, which can result in higher brokerage fees. You won’t pay these fees if you are investing in a 401(k), but you could if you were making monthly purchases of a stock or mutual fund. You can mitigate these fees by investing quarterly or semi-annually.

Conclusion

The point of dollar cost averaging is not to try and time the market – it is to save or invest with amounts of money you can afford. The amount you can invest could be as low as $25 a month or into the thousands. The point is to get into the habit of investing, and dollar cost averaging provides investors with an easy and affordable way to invest money on a regular basis.


Published or updated February 27, 2011.
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{ 14 comments… read them below or add one }

1 Eric

I like the example in the intelligent investor where graham talks about lumping a single time investment of 10k into the market in the 1920’s, verse stretching that investment out over time. It really highlights the benefits of dollar cost averaging and how it not only limits you losses when the market takes a hit, but can actually increase your investments value.

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2 Andy

Good concept but in today’s market where we are seeing huge falls, DCA may not be the best approach. Wait till the bottom (or when things stabalize from the near panic we are in) and then do a lump sum investment. Or even better just stay out of the market for now!

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3 Ryan

Eric: True, but it can work the opposite way as well. I think for most people it is just the easiest way to incorporate investing into their habits (payroll deductions for a 401(k) are a prime example).

Andy: The problem with that approach is that it relies on timing the market and many people don’t know enough about the market to know when it has bottomed out. DCA allows people without much investing knowledge to put in money when they have it instead of trying to time the market. If you are a serious investor and are well versed in the markets, then lump sum investing is probably a better bet.

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4 Dividend Growth Investor

I did a study on DCA using historical prices from VFINX ( Vanguard S&P 500 mutual fund) from 1988-2007 and concluded that dollar cost averaging doesn’t work most of the time. It only outperformed a lump sum investment for contributions beginning in 1994, 2001, 2002 and 2008.
Anyways, it’s still being done however, as most people get their retirement contributions every other week or every month from their paychecks..

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5 Ryan

DGI: I think that is the point – for most people, DCA is the easiest way to invest (especially for 401(k) plans which require payroll deductions). Set it up once and forget about it until it is time to do an annual portfolio rebalance. For those who actively trade and invest (such as yourself), DCA is probably not the way to go. I’m in favor of DCA if it means someone will invest rather than spend the money without thinking about it.

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6 dan

Its called INVESTING not GAMBLING! We dont ask our broker to put it all on #7 and spin the wheel. I like the idea of DCA! As Andy (above) mentioned “right now was not the time for investing and just to stay out of the markets for now!, I ask when is the bottom?

Yes there are good points and bad, but at the end of the day just think if andy would have bought through a DCA program over the last twelve months he would be much happier and not terrified from times to come as the market comes back over time. Also, some investors dont have a lump of 10K+. its an option as opposed to an obligation!

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7 Dokuen

DGI, without reading your report and assumptions it is impossible for us accept your claims on faith. I assume that you assumed (here we go) each investor had a lump sum available to invest. For example, given 2 investors with $10k did you assume the DCA investor held their funds in a non-interest bearing account while buying shares on a monthly basis and the LS investor put it all in the market? Not really a fair comparison if that is your case. When I have a lump sum, I put it in the market…when I don’t I DCA. I constantly buy stocks. Yes, I kept buying while the market tumbled and I am still buying now. I have yet to find anyone that can consistently beat DCA over time by timing the market.

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8 alex

where do i go/who do i speak to about investing ?

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9 Ryan

Hi Alex, You can contact a financial planner/advisor to help you get started. Alternatively, I have an article here that you may find helpful: Beginner Investing Strategies.

Best of luck.

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10 William

How can retirees benefit from DCA? With onlyfixed amonts of funds each month to invest !

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11 Felicia

William,

Open an IRA or Roth IRA, and have money automatically sent to that account each week/month, depending on your budget. It’s actually quite simple; research those that have no fee/opening minimum, if you don’t have the available cash at the moment. I used zecco.com to open my 1st Roth account, on a very limited budget. Best of Luck.

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12 Randa

With the way the market is now, and with the prediction that another crash is going to happen this year when inflation catches up with us, alongside the resulting unemployment increase; would you start an IRA now, or wait a year or two to see how things turn out?

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13 Ryan Guina

I would start an IRA as soon as possible – in general, the longer you have your money in the market, the better. Additionally, it is virtually impossible to time the market. If you have concerns regarding investing all at once, then invest on a monthly plan or contribute several times per year. They key is to just get started.

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14 George

Guys,

I’m a new small time invester… What do you think about my following strategy:

1. diverisifying my portfolio: I’ve invested $500 to $1500 between some ten stocks to a total of around 8000 bucks in the last month. This is split between blue chip and newer companies or companies that are currently undervalued and have potential for growth across different sectors like tech, airline, financials, healthcare
2. Dollar cost averaging:I’m setting aside 1000 bucks a month to invest into the market. My plan now is to top these existing investments 1000 bucks each when they go much lower than my initial cost.
3. I might buy more new stocks along the way to increase my portfolio if there isn’t a drastic dip in any existing stock
Would appreciate your thoughts on this strategy.

Thanks

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