Understanding Dollar-Cost Averaging (DCA)

Every investor fears losing money. This fear can actually keep some people from investing, and it might also lead to selling preemptively or opting for a lower risk investment option.

To minimize the fear of losing money, investors sometimes choose to go with a risk-reduction strategy such as Dollar-Cost Averaging (DCA). 

The majority of academic research has shown that while dollar-cost averaging may help to manage risk, on average, it just reduces returns (and therefore is inferior to lump-sum investing). However, the popularity of DCA remains high.

Research has shown that the pain of losses is more severe than the joy of gains for investors¹, so risk-averse investors may prefer to dollar-cost average simply to minimize the potential regret of seeing markets decline shortly thereafter.

What is DCA?

DCA is an investment tactic in which a fixed amount of money is invested at regular intervals. The goal of DCA is to provide the investor with a lower average cost of shares over time. Since the investment amount will be the same at each interval, the idea is that more shares will be purchased when the price is low than when the price is high.

Those who support the use of DCA claim that it can provide a lower average purchase price for a risky asset, proposing that purchases of assets (that are higher risk) with DCA when prices are declining will provide better returns than lump-sum investing.

The Possible Benefits

By only investing a portion of your lump sum, price drops will not impact your portfolio as heavily as if you invested a larger portion. Dollar-cost averaging is meant to mitigate the risks involved in lump-sum investing, through which an investor could face major losses if the market crashed or prices fell drastically.² 

Market fluctuations and losses can greatly affect an individual’s emotional well-being. Further, emotional responses to these ebbs and flows, such as overconfidence or panic, can affect future investment decisions.³ Since only part of a sum is exposed to the market, losses may not be as drastic. Therefore, many individuals may experience a duller emotional reaction than if all of their money were affected, decreasing the likelihood of making emotionally-driven investment decisions in the future.³

The Possible Downsides

When employing dollar-cost averaging, portions of your money are uninvested and cannot grow. The main argument against DCA is that these portions are not given the chance to accumulate any returns. 

In lump-sum investing, a larger portion of your money is given the chance to make gains sooner rather than later. However, investing a significant portion of your money also means that you may experience more pronounced losses in a vacuum. Over time, however, you can make up for these losses. 

This long-term thinking also supports dollar-cost averaging. 

When to Consider Using DCA 

Investors might choose to employ dollar-cost averaging for a variety of reasons:

·      Volatile investments

·      Other long-term investments, such as 401(k)s or IRAs

·      A time in life where any volatility is undesirable and may cause immediate ramifications (i.e. nearing retirement)

·      Individuals who are risk-averse 

·      Individuals who do not have the funds for a lump-sum investment 

The alleged benefit of DCA is that it encompasses the unpredictability of the market, but it tends to lower the cost of your shares as a result. When choosing how to invest, it is wise to seek the counsel of a financial advisor who can help you make the best choice for your circumstances and goals. 

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