Dollar-Cost Averaging Is a Great Investment Strategy, but Here’s When It Doesn’t Pay
I love the concept of dollar-cost averaging. It means you're investing a set amount into the stock market in routine intervals regardless of the market price (ie: every two weeks, each month, etc).
For instance, if you invest 20% of your paycheck every two weeks, you're dollar-cost averaging. You're not buying low and selling high. You're just consistently investing. Using the power of financial automation, set up 401K/Roth IRA deductions or bank transfers into investment accounts, and you don't even have to think about it.
Dollar-cost averaging (DCA) is an investment strategy where an investor consistently invests a fixed amount of money at regular intervals, regardless of the asset's price. This approach aims to reduce the impact of market volatility on an investment.
Here's how it works:
- Consistent Investments: Instead of making a lump-sum investment, the investor invests a fixed amount of money regularly, such as monthly or quarterly.
- Market Fluctuations: As asset prices fluctuate over time, the fixed investment amount buys more shares when prices are low and fewer shares when prices are high.
- Averaging Out Costs: The strategy aims to average out the overall cost per share over time, potentially lowering the average cost of the investment.
- Long-Term Perspective: DCA is often used with a long-term investment horizon, allowing the investor to benefit from the potential growth of the investment over time.
DCA is considered a disciplined and risk-averse approach, helping investors avoid the challenge of trying to time the market. It is commonly used in stock market investments, mutual funds, and other types of securities. The key is consistency in investing, regardless of short-term market fluctuations.
It's a great philosophy, but that doesn't mean that DCA is always the smart bet.
When Dollar-Cost Averaging Doesn't Pay
When it comes to your salary, I'm a firm believer in the DCA strategy. Just invest a portion of your check every month. Set it and forget it.
In 20 years, you'll likely be sitting on a nice nest egg.
But what if you're sitting on a chunk of money from an inheritance, bonus, or anything else? Should you invest a portion of it every month until it's all invested (the dollar-cost averaging approach), or invest the entire lump sum into the market all at once?
The answer, according to the numbers, is to invest it all at once.
As Vanguard found, it's usually better to invest a chunk of money all at once rather than spacing out those investments over time.
“Using MSCI World Index returns for 1976–2022, Finlay and Zorn calculated that [lump sum] outperformed [cost averaging] 68% of the time across global markets measured after one year. However, [cost averaging] was still better than remaining completely in cash; it outperformed cash 69% of the time.“
Why? Because the market usually goes up.
And that means the longer your money is invested, the higher your potential returns. And this is especially true during a raising market. The quicker you can get that money invested in the market, the more money you stand to make.
If you're into numbers (I mean, really into numbers), here's an excellent resource dissecting lump sum vs. cost averaging in excruciating detail, with many charts and graphs.
“When deciding between dollar cost averaging vs lump sum, it is almost always better to lump sum (invest it now), even on a risk-adjusted basis,” Maggiulli wrote. “This is true across asset classes, time periods, and nearly all valuation regimes. Generally, the longer you wait to deploy your capital, the worse off you will be.”
If you're not in the mood to get into the weeds here, just understand this: You're statistically better off investing a chunk of money all at once rather than spreading it out over the course of months.
To reiterate, keep DCAing your salary. Take a portion of your check and buy appreciating assets every month. It's easy. Use automation to make the process mind-numbingly simple.
Lump sum invest money you get from an inheritance, end-of-year bonuses, business sales, bank robberies, or anything else.