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Dollar-Cost Averaging (DCA): Who Should Use This Investment Strategy? Thumbnail

Dollar-Cost Averaging (DCA): Who Should Use This Investment Strategy?

It’s natural for investors, especially new investors, to worry about losing money—it stops some people from ever investing at all. It can also lead to preemptive selling or opting for investments with lower risk than necessary. Some investors manage their fear of losing money by using a risk-reduction strategy called Dollar-Cost Averaging (DCA).

DCA is an investment tactic in which you invest a fixed amount of money at regular intervals, just as with workplace retirement savings plans like 401(k)s. You buy more shares when the market is down and fewer shares when it’s up. If share values drop, as long as the investor is still buying, he has the consolation of achieving a lower average cost of shares over time.

Those who support the use of DCA point to this lower average purchase price, proposing that purchases of assets using DCA when prices are declining will provide better returns than lump-sum investing. Since markets tend to increase over time, this claim is of limited financial usefulness, but some find the emotional reassurance worth it.

Most academic research shows that DCA reduces returns on average, making this strategy mathematically inferior to lump-sum investing. But DCA remains popular: it is widely believed that the pain of loss is greater than the joy of gain. Risk-averse investors may prefer to use DCA, reducing the potential regret of seeing markets decline shortly after a significant investment.

Pros and Cons of DCA

Risk Mitigation and Managing Emotions

Suppose you have a lump sum to invest; imagine how you’d feel if your investment fell right after you bought it. By investing only a small portion of your lump sum, price drops will not impact your portfolio—or your emotions—as heavily. DCA mitigates the risk of loss involved in lump-sum investing. So, risk-aversive individuals may prefer to use DCA.

Market volatility is often compared to a roller coaster, but speeding downhill isn’t especially fun when it comes to investing. Our emotional responses to these natural market fluctuations, such as overconfidence, can affect future investment decisions.1 If you know that by investing a little at a time, your initial losses will not be as drastic if the market experiences a downturn, the distress associated with market losses could be blunted.

Missing Out On Gains

Using DCA leaves a portion of your money to sit uninvested, accumulating little if any return. As a result, some investors and financial professionals prefer other strategies that expose a larger portion of your funds to the market’s risks and benefits.

Investing a larger lump sum positions more of your wealth to take advantage of statistically-more-likely gains sooner rather than later. The Vanguard Group, in their whitepaper, “Dollar-cost averaging just means taking risk later,” notes their findings that investing lump sums outperforms DCA about two times out of three.

Still, even if lump-sum investing is statistically more likely to outperform, that is not the same as certainty. Ultimately, the decision to use either approach will depend on your unique situation. We typically prefer to invest windfalls as a lump sum, but that does not mean that it is the best option for everyone.

When to Consider Using DCA

Some reasons to use dollar-cost averaging include:

  • When you have no other choice—retirement plans funded through payroll deduction, such as 401(k)s, may not allow any other way to invest.
  • If you don’t have the funds for lump-sum investing, and your capital will come from your ongoing earnings.
  • If you’re generally risk-aversive.
  • If you’re inexperienced in investing and don’t know how you’ll react to a market downturn, or if your prior experience shows you have a strong negative reaction to market losses.
  • If you believe what you’re investing in could drop in value, so spreading out your investment could allow you to buy more shares when they cost less.

Regardless of how you choose to invest, we advise against looking at investment performance for at least a few months after you buy. It’s very rare to invest at the ideal time, but investment success doesn’t require you to do so. The important thing is to invest in a portfolio designed to respect your tolerance for risk and to support your investment goals, whether for retirement, legacy, or something else.

The process of DCA acknowledges the market’s unpredictability and intends to lower the cost of your shares as a result. When choosing how to invest, it is wise to seek a financial advisor who can help you make the best choice for your circumstances and future goals.

Be sure to check out our most recent video, Ken explains some issues to watch for in Roth conversions.

1. https://www.aeaweb.org/articles?id=10.1257/jep.29.4.61

This content is developed from sources believed to be providing accurate information and is provided at least in part by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Original content of Practical Financial Planning, Inc. only is copyright © 2020 by Practical Financial Planning, Inc.