Dollar Cost Averaging (DCA)

Successful investing is about time in the market, not timing the market. - old investing adage

Predicting the stock market is incredibly difficult. Even the professionals struggle to do it reliably, with only 20% of active fund managers have outperformed the market over the last 15 years according to the S&P 500 Versus Active Funds (SPIVA) report.

This can be a frightening prospect when you are just starting out. If you have never invested before, deploying your hard earned savings for the first time is a big step, and it's natural to wonder whether right now is the best time to take that step. This fear of loss can be paralysing, and cause you to continually postpone or put the decision off.

It's like taking an ice bath. The reality is that the water will never get any warmer, and you just have to take the plunge.

Fortunately, there is a strategy called dollar cost averaging (DCA) that we can employ to reduce the risk of loss and make taking the plunge slightly easier. Dollar cost averaging is the process of investing small amounts of money into the market at regular intervals, regardless of market conditions. This is opposed to lump sum investing, which involves investing 100% of your money into the market at once.

For example, if you have $500 to invest, you don't have to put all $500 into the market at once (lump sum investing). Instead, you might split your $500 into 5 investments of $100 at the start of every month for the next 5 months.

Lump sum investing places a great deal of importance on the timing of your purchase. If you happen to buy just before prices fall, your returns will be significantly impacted. Dollar cost averaging (splitting your purchases over time) reduces the impact of market timing on your investments. If the market goes down after your first purchase, you benefit by being able to buy more shares at a discounted price with the money you saved. And if the market goes up, at least you made money on your first purchase.

The beauty of dollar cost averaging is that by splitting your purchases into equal dollar amounts, you end up buying more shares when prices are cheap and less shares when they are expensive. This means the average price you end up paying is balanced out over time.

Dollar Cost Averaging vs Lump Sum Investing

Dollar cost averaging is a risk reduction strategy. And according to the universal relationship between risk and reward, any time you reduce risk you must expect a lower return.

The flaw with dollar cost averaging is that if markets go up, you will make less money. And this flaw is not insignificant, especially when considering that the market always goes up over the long-term.

Research by Vanguard shows that lump sum investing has historically outperformed dollar cost averaging 68% of the time.

This result is roughly what we would expect, considering the S&P 500 has historically experienced a positive annual return 70% of the time.

Dollar Cost Averaging Simulator

Use the simulator below to see how dollar cost averaging and lump sum investing compare in different market conditions.

Practical Tips for Reducing Risk

If lump sum investing is statistically the better thing to do, should you always invest 100% of your money up front?

This decision is highly subjective. If you have a low risk tolerance or are particularly worried about current market conditions, splitting your purchases up over time may be appropriate.

Dollar cost averaging is an ongoing process which requires your involvement every time you wish to purchase shares. It's not a trivial task to stick to your investment plan once you make it. Fortunately, some brokers allow you to set up recurring buy orders to handle this for you, although availability is limited in Australia.

The debate between dollar cost averaging and lump sum investing assumes that you have 100% of the money you wish to invest up front. In reality, your money usually accrues incrementally (presumably from your salary). Unless you receive a large sum of money all at once, your investment strategy should naturally be a recurring process anyway.

Every time you receive a paycheck, you should invest a portion you are comfortable with into the market, regardless of market conditions.