An oft-cited tenet of investing philosophy that has been passed down over the years is that Dollar Cost Averaging (DCA) is a good way to invest in a risk-managed manner, particularly for beginning investors.
The basic approach is that you invest a consistent amount at regular intervals, which ensures that you buy more shares when prices are low (and fewer shares when they're higher). You engage in DCA with each 401(k) contribution, and with any systematic investments you make to an IRA, 529 plan or a taxable investment account.
For instance, if you had $8,000 to invest at the beginning of this year, and decided that you simply wanted to invest in an index fund that tracks the S&P 500 Index, you could have chosen the SPDR S&P 500 Exchange-Traded Fund (SPY)*. You would have then faced the decision of when to invest the money. Doing so on January 1 would have allowed you to buy at $128.68. Investing $1,000 on the first day of every month would have given you an average cost of $131.16, because prices trended higher through much of the first half of this year.
Is it a good idea?
Probably the most logical comparison to make is between DCA and lump sum investing. In other words, if you don't have a lump sum that you could invest at the beginning of a period, but want to invest on an ongoing basis, your decision to dollar cost average is pretty straightforward.
What if you do have a lump sum that you could invest? Should you average into the market over time?
While DCA may feel better to a lot of investors, the fact is that it doesn't result in better aggregate returns. If you had $10,000 ready to invest at most points in history, you'd be statistically better off putting it all in the market rather than averaging in over time. Why? Because the market typically goes up. I know, I know, it doesn't seem like it, especially after watching CNBC the past few weeks. However, between 1970 and 2010 most sectors within the stock market showed a loss in only 7-9 of the 40 years, depending on the sector. Since 1926, it's more like 20 years, out of 84. I don't want to sound too analytical, but the stock market goes up more than it goes down. It stands to reason that investing a lump sum at the beginning of a period will generally do better than spreading it across a series of investments over a number of years. Of course, you may not want to break that data out at a cocktail party with somebody who went all-in in May of 2008.
The decision to invest the lump sum is more obvious for the dividend enthusiasts among us. Waiting to get into the market could mean foregoing dividend payments. Those dividend payments can be reinvested, and over the long run they will contribute significantly to the overall returns of a stock market investment.
Does it ever make sense?
A Dollar Cost Averaging approach to investing matches up nicely with most savers' ability to invest. Not many of us have a pile of cash sitting around looking for something to do. Not to sound like Yogi Berra, but if such a pile exists, and we invest it, it no longer exists. Systematic investing makes a ton of sense, and that implies that DCA is at work. The discipline and forced savings that accompany such an approach are key components of building wealth, and in that sense Dollar Cost Averaging makes a ton of sense.
*Not a recommendation to buy a specific security.