Dollar cost averaging (investing like a robot) has received a bad rap in recent years, and for good reason. For those not investing in low or zero transaction cost accounts such as 401K’s, fees can really diminish your returns. This is especially true for those being managed by an adviser who gets a cut every time he executes a trade for you.
Lump-sum investing does have its merits during times of consistent economic growth and/or low volatility periods. However, when the market takes gigantic losses and is highly volatile, as it has been over the past year – or you are investing in zero transaction cost accounts, the merits of dollar cost averaging have returned with a vengeance.
What is Dollar Cost Averaging?
If you’re unfamiliar with the strategy, dollar cost averaging is distributing your investment contributions over time versus large lump sum payments. An example of dollar cost averaging is the process of having a consistent percentage taken out of your paycheck each pay period and having that amount contributed to your 401K. The same kind of discipline can be used in dividend reinvestment plans (DRIPS), or manually by you with all investment purchases.
How Does Dollar Cost Averaging Perform?
If you had invested lump sum amounts on Jan. 1 of each of the last 8 years vs. spreading that amount out at the beginning of each month, dollar cost averaging would have resulted in better returns in 5 of the 8 years, and absolutely destroyed lump sum investing in 2008.
Why Dollar Cost Averaging is Good for All (Especially Newer) Investors
1. Buy More on the Cheap
If you invest all at once in one lump sum when the times are good, you don’t have any money left for when shares are cheap. Buying cheap means better gains when the market does rebound.
2. Removes Emotion
Dollar cost averaging forces discipline at times when investing doesn’t seem to be the best idea. Study after study shows that once emotion becomes involved in your investing strategies, your results are going to be impacted in a negative way.
3. Helps you Avoid Timing the Market
Adding shares on a strict, regular basis means that you avoid trying to time the market. Day trading is for experts who live and breathe the stock market 12 hours + per day. Even they struggle at times to achieve market beating returns. What are the chances you can beat the pros by clicking ‘buy’ and ‘sell’ on your lunch break a few times per day, week, or month?
4. Distributes Risk
If you were to make large lump sum payments, you can easily get burned buy putting your money in at the wrong time. Think Dow 14,000 in December of 2007 and Dow 8,000 in November 2008. At the same time, you’d have nothing left to buy shares at recent price lows.
5. Lowers Stress
Large investments all at once can result in a great deal of stress in trying to figure out if ‘now is the right time’. The answer is, nobody truly knows. Investing via dollar cost averaging removes the stress of playing the guessing game.
Final Thoughts on Dollar Cost Averaging
Everyone loves to hate the concept of dollar cost averaging (it’s not quite as dramatic or fun, after all). However, straying far from this strategy can lead to disastrous results in volatile times.
Dollar Cost Average Discussion:
- Do you dollar cost average?
- Why or why not?
I use DCA in my 401(k) & my ROTH (when i have the money to invest in my Roth. :[)
I contribute to both my Roth and my 403(b) monthly, the only time I’ve ever made a “large” investment at once is when I opened my Roth, and even that was only $700.
@Stephanie – sounds like a good strategy. Are you strictly in mutual funds at this point?
For now, yes. I think within the next year I’m going to start finding other places to invest some “non-retirement” money, since my plan is to retire before I can actually start drawing from my retirement investments.
I invest every month or every -two- months for the above and for the sake of making every penny count.
I only have a handful of stocks that I invest in (as in, under 20) because I like to make sure that I am familiar with the company that I am becoming part owner of. Considering this, every month some stocks will be slightly cheaper than usual, meaning I’ll be able to increase my investment by a point or two the first year of the ownership.
The reason I say I invest every month or two is because sometimes the stocks will almost all be a bit higher than they should be, meaning I might just wait a few days or weeks in order to catch the market when I can earn a few more points.
Call me a perfectionist, but it works so far. And it’s a blast. ;-)
I tend to buy only ETFs and/or mutual funds and stay away from company stocks all together. These days a lot can be manipulated and changed.
I’m just getting started, so I only DCA – I simply don’t have large sums of money saved up to invest all at once. About $400 a month into my 401(k) and about $1000 a month into my company’s employee stock plan – but that is all invested at once, every three months, in a $3000 lump sum, so it will feel more of the effect of volatility. Still, I’ll be buying every three months rain or shine. Yeah, not terribly diverse, but my company has an incentive plan. Very stable company, P/E is very low right now especially compared to the norm for this company, etc., so I feel comfortable leaving my money to hang out there for a long period of time.
Once the stock price starts to rise significantly again I’ll probably sell each month as well – I’ll still be buying to get the incentive from my employer, though, but will sell about twice what I buy – and then I will start sinking the money into my mortgage as we get close to another high. That way, I can feel comfortable selling as the price climbs without worrying that I am missing “the big high”.
At least, this is the plan. I’m just getting started, so *insert grain of salt here*.
Sounds like what you’re doing is similar to Value Averaging.
In my opinion, and owing to current market conditions, dollar cost averaging or buying shares as they fall away because they seem “cheap”, is not smart investing for the simple reason that most investors do not know where the bottom is and to buy without knowing is speculating.
Interesting point Andy. It is speculating, but isn’t all investments, whether it be in company stocks or mutual funds and the like, speculation? No one ever really knows how low prices will fall. Therefore I would have to disagree on it not being smart investing for the long term, unless you mean buying because it seems cheap when one knows very little to nothing of what the company or mutual fund actually does or how it’s operated. With day trading and short term investing you’re probably right.
I’ve recently started investing and have been doing dollar-cost direct into company stocks, avoiding mutual funds altogether. I do pick stocks that seem undervalued, or seemingly cheap, but only after adequate research of what the company does and what their outlook for the future is. And by that I don’t mean how much they say they’ll make in profits (Enron said they were making money and we all saw how that ended), instead by what products and/or services they plan and if they plan on expanding or not. I do make investments for the long term as I’m not a day trader.
I like the reduction of risk DCA provides, but I’ve been thinking it may be good to max out your 401(k) early in the year (plus employer match) so you get more money earlier (time is money).
If you think that’s too risky you can set up your 401(k) so all new contributions get into bonds and then move it into stocks throughout the year. I’m not sure I’ll have the patience for this but I think I’ll try to max out as early as possible next year.