Tuesday, November 08, 2011

Does Dollar Cost Averaging Work

By Rajiv Hargunani

Dollar Cost Averaging or Lump-Sum Investing: Which is better?

In its simplest form, Dollar Cost Averaging or DCA is investing a set amount of money at regular intervals. It has been considered a “safer” way to invest in markets because it takes the guess work out of the equation. Instead of trying to time the highs and lows (a daunting task, even for professionals), you're investing the same amount of money at regular intervals.

In theory, by following this approach you will be investing regularly regardless of the economic news, market cycles, Fed meetings, interest rates etc. Does this strategy sound familiar to you? It should. This is how majority of the participants invest in their retirement programs at work. They may choose to call it by a different name such as periodic investing or monthly investing but in reality, they put in a fixed percentage of their salary into the investment choices available to them.

Here is a simple example to illustrate how Dollar Cost Averaging works:

Period (Monthly, Quarterly)	Fixed Dollar Amount	Price of Investment ABC	Number of Shares Purchased
1	$300	$30	10
2	$300	$20	15
3	$300	$10	30
4	$300	$40	7.5

As the table illustrates, you purchase more shares when the price of the investment is low and fewer shares when the price is high.

It aligns perfectly with the goals of the long-term, buy-and-hold investor, who is only able to invest a certain amount each month. In cases where you don’t have a choice, such as retirement programs offered at your place of work or you only have some savings left over at the end of the month; this may be the only way to invest.

Benefits of Dollar Cost Averaging

Over a short period of time, the primary benefit of using this strategy is that it reduces the potential of huge losses. This is more psychological than anything else because the idea of spreading out the investment dollars over time gives the investor the feeling that this is less risky than lump sum investing.Substantial research has been done to show that the thought of losing money is more painful than the joy obtained from any gains. Maybe for this reason, individuals think investing a set dollar amount on a periodic basis will prevent them from potentially losing large sums of money.

The second benefit in my opinion has to be convenience. Just like setting up the payment of your monthly bill, setting up an investment program like Dollar Cost Averaging is very easy.

Thirdly, this kind of investment program forces you save. Money that goes off directly from your checking account (or paycheck) into a DCA investment program helps you build a sizeable asset over time.

Finally, it takes emotion out of the decision making process.

Alternate to Dollar Cost Averaging: Investing a lump sum

What about the case where you win the lottery, rollover your 401(K) into an IRA or receive a huge inheritance, would you still want to go with the DCA philosophy? Which strategy, lump sum or DCA, would be the right one? The answer boils down to several factors such as economic conditions, your financial goals & objectives, volatility of the stock market, your (or your adviser’s) ability to manage risk, your own risk tolerance etc.

Lump Sum (LS) investing does have its own merits. You can achieve your desired asset allocation by spreading out your money into the various asset classes such as, domestic & international equities, real estate investment trusts, commodities, domestic & international bonds etc. If you do have a lump-sum, and you still decide to invest using the DCA philosophy, your asset allocation will be skewed heavily towards cash, which may affect your total return. Having a sufficiently large time horizon may help you ride out the volatility of the markets. This is probably one reason why lump sum investing may outperform DCA because your money stays longer in the markets.

No strategy can eliminate risk and it won’t protect you from losses. The DCA philosophy assumes you will have capital and the discipline to invest through vicious down cycles like we have seen recently (2007-2009). Markets can stay low for a long period of time as in the case of Japan which peaked in 1989 and is down roughly 75% after 22 years.

Conclusion

The bottom line in choosing between lump-sum investing and dollar cost averaging comes down to how much risk you want to take. Sequence of returns can greatly impact the performance of both strategies. Lump Sum investing requires solid risk management strategies to prevent losses from becoming massive. The point of dollar cost averaging is not to try and time the market – it is to save or invest with amounts of money you can afford, helping investors build a sizeable asset over time.

Disclaimer:

Investors are reminded that dollar cost averaging does not assure a profit and does not protect against loss in declining markets. Since it does involve continuous investments in securities regardless of fluctuating markets, investors should consider the willingness to continue purchases during market downturns.

Other posts by Rajiv Hargunani:

Rajiv Hargunani
This material was prepared by Rajiv Hargunani, Financial Advisor of Raymond James Financial Services, Inc., Member FINRA/SIPC
Ash Place 2100 16th Ave S, Suite 1, Birmingham, AL 35205
Telephone: (205)939-0100

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