Dollar Cost Averaging Explained
The dollar cost averaging strategy was first advocated by Benjamin Graham in his 1949 book, The Intelligent Investor. In it, Graham, who is reverently referred to as the “father of value investing,” describes dollar cost averaging as follows:
“The practitioner invests in common stocks the same number of dollars each month or each quarter. In this way, he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.”
Understanding when it is appropriate to use dollar cost averaging versus lump sum investing will not only improve your financial literacy, but also could enhance the performance of your investments over time.
When Is Dollar Cost Averaging Beneficial?
The objective of dollar cost averaging is to mitigate the oftentimes volatile nature of asset prices (particularly, stock prices) and ensure a prudent average acquisition cost over a period. This occurs via the disciplined execution of a periodic purchase plan, which results in the blending of above-average and below-average buy points.
Beyond the mathematical logic, dollar cost averaging is an ideal way to overcome the often-perilous attempt to “time the market.” By executing purchases at specified intervals, without emotion or hesitation, an investor can avoid many of the behavioral biases and momentum traps that can lead to investing large sums of money at ill-advised times (high-cost points), thereby improving the potential to accumulate wealth.
Read More: Investing for Beginners
Examples of Dollar Cost Averaging
Example 1: 401(k) Contributions
The most common example of dollar cost averaging occurs with individual 401(k) contributions. A 401(k) is a tax-advantaged, employer-sponsored defined contribution plan that helps many of us save for retirement. A 2022 study from the Investment Company Institute estimated 401(k) plan assets totaled $7.3 trillion comprising almost 20% of total retirement assets — $37.5 trillion — in the United States.
The 401(k) plan, which can be established by employers based in the U.S., entails recurring employee contributions via payroll deductions. For those on a biweekly pay schedule, this equates to 26 distinct contributions, while semi-monthly and monthly pay schedules are comprised of 24 and 12 contributions, respectively.
Regardless of the pay frequency, the contributions are equal in size, and they occur at regularly planned intervals. Moreover, as the contributions are received by the plan, the money is automatically invested in previously specified assets. This preplanned, methodical and disciplined approach to buying financial securities is the essence of dollar cost averaging.
Example 2: DRIPs
Another fairly common example of dollar cost averaging occurs with dividend reinvestment plans (DRIPs). A DRIP is a program that allows an investor to automatically invest cash dividends received into additional shares or fractional shares of the distributing equity investment.
Initially, these programs were administered directly by dividend-paying public companies. Today, the opportunity set is much more expansive, as brokerage firms administer these programs for an array of mutual funds and exchange-traded funds.
Like 401(k) contributions, the periodic, automated purchases facilitated via a DRIP exemplify dollar cost averaging. While the dividend amounts can vary from period-to-period, the methodical and disciplined deployment of cash received fundamentally aligns with the notion of dollar cost averaging.
Read More: What Is a Dividend?
Example 3: Financial Securities
A third, less structured and more manually intensive application of dollar cost averaging could occur anytime one comes into a large sum of cash that is to be invested in financial securities. This could happen in a variety of scenarios, such as the receipt of an inheritance or the collection of proceeds from the sale of real estate.
Regardless of the source, a confident investor may know exactly how the funds are to be invested. However, the investor may be inclined to exhibit some patience and extend the asset acquisition over a meaningful amount of time.
Let’s flesh this out with some details.
Assume John receives a $240,000 after-tax inheritance from his late Uncle Dave. John is a fairly experienced investor, with minimal near-term liquidity needs and a generally higher-than-average tolerance toward risk.
All of this encourages him to fully invest the unexpected windfall in publicly-traded equities. Specifically, John intends to buy VT, the Vanguard Total World Stock Exchange Traded Fund, a low-cost, passively managed fund that offers highly diversified exposure.
John likes seeing his money accumulate, so he is eager to get the cash invested. However, he also is cognizant of how volatile equities can be, especially during uncertain economic times.
The last thing he wants to do is invest the entire $240,000 on a day that turns out to be a 52-week high for VT. So, John devises a plan to invest $20,000 on the first and 15th trading days of each month for the next six months.
In the meantime, he deposits the undeployed cash in a high-yield savings account to safely garner as much interest income as possible. John’s thoughtful implementation strategy is a prime example of dollar cost averaging.
A Closer Look: Dollar Cost Averaging vs. Lump Sum Investing
Delving in further, over the next six months, John invests as illustrated below.
|Transaction Sequence||Stock Price||Amount Invested||Shares Purchased|
Had he immediately invested the entire $240,000, John would have bought 2,400 shares at $100 per share.
Six months later (following the 12th purchase), at the same share price of $100, his position would have been equal to the initial $240,000 investment.
However, John utilized dollar cost averaging, and he gradually invested the $240,000 at an average price of $88.75 per share. This enabled him to amass 2,738 shares (338 more than the lump-sum approach).
His fixed investment of $20,000 every two weeks bought more shares when the stock price fell, and fewer shares when the stock price rose. As a result, his ending market value was $273,800, over 14 percent higher than the lump-sum approach.
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Dollar Cost Averaging Drawbacks and Considerations
While dollar cost averaging can help ensure a prudent average acquisition cost over a period and overcome many of the behavioral biases and momentum traps that plague investors, it has a few situational drawbacks and cautionary considerations.
Firstly, dollar cost averaging is merely a technique that has the potential to enhance investment performance over time. It does not protect against the risk of declining prices and loss of capital.
Beyond this overriding caveat, I offer the ideas outlined below — ranked in order of mainstream relevance.
Long Investment Horizons
Relatively long investment horizons often lend themselves to lump-sum investment and minimal cash drag, not gradual dollar cost averaging. In these long-range scenarios, the return-diminishing impact of holding onto cash and failing to realize the power of compounding interest can overshadow the benefit of achieving a prudent average acquisition cost. Of course, this idea is irrelevant for something like a 401(k) plan, where money can only be invested gradually — as you earn it.
Higher Brokerage Fees
Dollar cost averaging leads to a higher volume of transactions, which can result in higher brokerage fees and lower returns. In recent years, stiff competition in the brokerage industry has caused significant fee compression, making this less of a concern. Nevertheless, in some situations, it remains a relevant consideration.
Rare, Market-Timing Abilities
If you can effectively enter and exit markets at ideal times, dollar cost averaging is an impediment to wealth accumulation. For you, much like a high-stakes, professional poker player, big moves made at the right times are what it’s all about. That said, there are very few investors who can consistently demonstrate a successful track record. This holds true across the vast universe of individual investors, headline-grabbing hedge funds and institutional money managers.
Read More: Federal Tax Brackets
Dollar cost averaging is an investment strategy that entails making systematic purchases of an asset over a relatively long period. The purchases are relatively small and executed at regular intervals, which contrasts with a lump-sum acquisition.
The objective of dollar cost averaging is to mitigate the oftentimes volatile nature of some asset prices and ensure a prudent average acquisition cost over a period. Additionally, it enables avoidance of the behavioral biases and momentum traps that often lead to investing large sums of money at ill-advised times.
While the approach is theoretically sensible, it can be suboptimal for investors with long investment horizons and those with extremely rare, market-timing abilities. As with any investment strategy, its appropriateness is highly personal and subject to the unique circumstances of the investor in question.