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Does Dollar Cost Averaging Work? How Should You Use It?

August 25th, 2019 by 
PK

Dollar Cost Averaging is a set it and forget it investment strategy that lines up well with how your paycheck works. You're paid on a periodic basis, and if you use DCA... you turn right around and invest on a periodic basis too.

Today I'll talk about what dollar cost averaging is, how you should use it, and answer the burning question: does dollar cost averaging work?

What is Dollar Cost Averaging?

Dollar Cost Averaging is a strategy where you invest money into the same investments on a regular basis. You make those purchases without even looking at the price – again, dollar cost averaging is a set it and forget it investing strategy.

Investments rise and fall in value all the time. This means that you'll buy more of an investment while the price is low and less while the price is high.

On average, though, using DCA you'll get a middling price – which tends to increase over time.

Meme guy plus an arrow and the word "stonks" which is stocks

Benefits of Dollar Cost Averaging

There are quite a few benefits of dollar cost averaging, even beyond your investment in the stock market.

Here are a few benefits of dollar cost averaging:

  • Reduces cognitive load: Most of you – even if you work in finance – have better things to do than pick stocks every 2 weeks.

    Dollar cost averaging lets you set an investment up front and automate it. Then you only need to look at your plan at a scheduled time annually.
  • Avoids timing the market: Even if you are a very good investor, it's extremely hard (and others will say impossible) to time the market.

    Dollar Cost Averaging just plows ahead mechanically no matter the market conditions. You'll win some and you'll lose some, but it'll all average out over time.
  • Removes emotions from investing: If your money is on autopilot through a dollar cost averaging plan, you don't have to worry about your emotions getting in the way of making investments.

    You know you should invest, but it can be hard when you're fearful. If your DCA plan is still running, you don't have to worry – you'll buy the lows, highs, and everything in between.

Are There Drawbacks to Dollar Cost Averaging?

Alas, there are some downsides to dollar cost averaging. But: they are mostly avoidable (with the possible exception of management costs inside your 401(k))

Let's look at how to avoid dollar cost averaging pitfalls.

Avoid Costs when Dollar Cost Averaging

The first trap in dollar cost averaging is cost. Costs mainly appear through transaction costs or investment costs (such as management fees).

When you buy stocks or ETFs through most brokerage accounts, you have to pay a commission.

Commissions vary per brokerage, but assume for most brokerages it's somewhere between $5 and $100. It depends on factors such as whether you buy online or dial into a company to trade.

Those fees up quickly - especially if you average into multiple stocks or ETFs. And if you purchase mutual funds they might have a load which acts much like a commission.

You also have to watch for management fees.

ETFs and mutual funds come with management costs, and not all funds are created equal. You should look for low cost, no-load mutual funds and ETFs for your DCA plan. And if you only have high cost funds inside your 401(k), you need to appeal to your company to add better options.

Bottom Line: Dollar Cost Averaging is easiest with a no-load mutual fund. Alternatively for ETFs and stocks, look for a broker that has free trades. (Or invest in stocks which have free "Direct Reinvestment Plans" – also called DRIP plans).

Avoid Underperforming Versus Lump Sum Investing

I wrote about how lump sum investing is better for a windfall. That post holds up – if you receive a lump sum, you should generally invest it all at once.

However, there is negative benefit to saving up in order to invest a lump sum. The positive drift of the stock market works against you if you're out of the market.

Bottom Line: Unless you have foresight the market is about to drop, you will lose if you save your paychecks to make a later lump sum purchase.

How to Dollar Cost Average

Convinced that dollar cost averaging is the right everyday (well... every two week?) investment strategy?

Good – it's simple to get things going:

  1. Set your target asset allocation for your DCA funds (for example, 80% stock 20% bonds)
    • Revisit this on a periodic basis; perhaps once a year. Resist the urge to change too often.
  2. Apply your allocation across all your accounts where you DCA
    • For example, set your allocation across your 401(k) and an IRA
  3. Automatically send money to your accounts
    • For some accounts (such as your 401(k)) you can push money automatically. For other accounts such as an IRA or 529, you might need to deposit your paycheck in a bank account first then pull money.
  4. That's it. Go back to step 1 once a year or so.
Set up your dollar cost averaging. Evaluate once a year. Profit 📈

Does Dollar Cost Averaging Work?

The subtext here is: "will I make money from dollar cost averaging?".

And the answer? Almost certainly, yes. Dollar cost averaging works over time.

The few scenarios where the answer is no involve population collapse, famine, war and other societal issues. In these pessimistic situations you have bigger problems than your retirement portfolio, however.

So, back to yes.

You're on Don't Quit Your Day Job... I'll prove it to you.

These next few calculators have periodic investing features. Using your own choice of inputs, you can see the effect of continuous investments into something:

*We don't – yet – have a mutual fund return calculator

Please use a long enough time period in your scenario. Dollar Cost Averaging is a strategy you employ over a career, not a few paychecks.

Dollar Cost Averaging Worked in the United States. What About Japan?

It's true – Japan's stock markets have been range-bound for a ridiculously long time. And since World War II Japan has had a relatively strong economy and avoided wars.

However, the stock market hasn't collapsed entirely. It's just that Nikkei lump sum investments in the 1980s have failed to keep up with inflation.

If you started your career in Japan in the late 1980s and continued to periodically invest, you would have also invested after the fall. You didn't perform as well as investors in the United States, but dollar cost averaging is viable even in Japan.

In Conclusion: You Should Dollar Cost Average Where You Can

You probably see a fair number of lump sums annually.

RSUs, ESPPs, bonuses, tax returns, asset sales, and (sadly) inheritances will all leave you with windfalls and require a different investment strategy.

But for your own peace of mind, the majority of your investing should be automatic. Wherever possible, plan your investing once a year – in advance – and put it on autopilot using dollar cost averaging.

And I'm not a hypocrite here.

I max my 401(k) annually, and time it to finish in December (to catch the full match). I send funds to my daughters' 529s twice a month, and once a month send money to a brokerage and a couple roboadvisor accounts.

I'd rather talk about efficiency here with you all than worry about where to put my money every two weeks. Even if DCA doesn't cover my entire investing strategy.

And don't you enjoy our time together? Let me know how you employ dollar cost averaging in the comments.

Don't Quit Your Day Job...

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