The Case Against Dollar Cost Averaging

At some point you were taught to invest a set amount each amount each paycheck. This was decent advice.

But you can do better.

Dollar cost averaging (DCA) is when you invest a consistent dollar amount on a systematic basis, usually monthly. The proposed benefit is more shares are purchased when prices are low, and less when prices are high. When allowed to play out, this mechanic can lower the average cost per share in a declining market or in a short term, volatile market.

Ok, great, but what about returns?

When examined in detail, dollar cost averaging doesn't actually enhance returns*. Although we would assume buying at a lower cost per share would boost returns, the average percentage return doesn't actually change when compared to a lump sum investment.

The main argument against a DCA strategy has to do with the tendency regarding which way the market generally moves. Since the market appreciates a bit over 2/3 of the time, keeping dollars out of the market in order execute a DCA strategy robs the investor of time in the market.

Here's what has historically happened when investors weren't all in the market for the time period January 1970 - August, 2008**.

It's important to be as fully invested as one can be for as long as one can be. So should you abandon the $250 flowing into your IRA each month? Not necessarily.

Let's say you have ample cash in savings at the bank. This cash is designed as your rainy day fund if you lose your job or need to cover an insurance deductible. You shouldn't raid it because you read this blog and I suggested you were missing out.

But let's say you've got a fully funded cash reserve as well as extra $$$ that could be invested.

In this scenario, DCA is usually inferior to investing a lump sum. This is because most DCA analysis assumes the investment will fall below the price of the original investment (providing the opportunity to buy at a lower price). But this actually happens less than 1/3 of the time, rendering the decision to hold onto potential investment dollars a poor one (on average).

Some argue that DCA can work over longer periods of market decline, like 2007-2009. I would say absolutely it's true in theory. DCA can play out favorably when the market depreciates. But how are you supposed to know when the market will decline? I would say if you're smart enough to know exactly when the market will begin its slide as well as when it will rise again (you're not that smart, but don't feel bad no one is), why would you even be talking about a DCA strategy? If you could predict future price movements, you'd be all in / all out based on your crystal ball forecast.

For some of us, we don't have a large sum of money sitting at the bank we're waiting to invest, which makes this whole DCA vs. lump sum argument moot. If you do have some spare scratch sitting around, on average and over the long run, it's a losing bet keeping it out of the market while you're executing your DCA strategy.

For those that have already invested what they can outside of their emergency reserves at the bank, the best strategy is to continue with 401(k) & IRA contributions on a DCA basis. This gets the most money you have at any given paycheck interval into the market, so it can go to work for you.

* Dollar Cost Averaging May Help To Manage Risk But On Average It Just Reduces Returns, Nerd's Eye View, Kitces, March 9th, 2016.

** Performance data for January 1970 - August 2008 provided by CRSP. Performance data for September 2008 - December 2013 provided by Bloomberg.Source: Dimensional Fund Advisors, 2014. Performance is based on index returns. The metrics above do not reflect the eroding effect of expenses, which would make the annualized returns for investors even lower. Indexes are not available for direct investment.

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