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Benefits Of Dollar Cost Averaging

8 February 2016 in Investing 101

Key Takeaways

  • Dollar cost averaging (DCA) is an investing method that involves investing a fixed amount of money in an asset on a consistent basis over time.
  • Dollar cost averaging can be useful for investors who would otherwise choose not to invest at all or who are unsure about how to determine entry points into a stock or ETF.
  • Motif Investing’s new recurring transfers feature can help you quickly get started with DCA today.

When you’re seeing a lot of red in your investment portfolio it can feel rather overwhelming. Volatile and downward trending markets can test even the most experienced investors’ patience and perseverance.

While you might be tempted to liquidate your positions and start stock piling cash, it’s best not to rush into anything drastic. If your big picture financial goals include growing wealth through investing, now is a good time to consider a trading strategy known as dollar cost averaging.

What Is Dollar Cost Averaging (DCA)?

In simple terms, dollar cost averaging is a trading method that involves investing a fixed amount of money in an asset such as a stock or ETF on a consistent basis over time. Using a set schedule to invest, regardless of the share price should result in more shares purchased when prices are low, and fewer shares bought when prices are high.

For example, you could initiate a DCA trading strategy to habitually invest $1,000 into Stock A at the start of every single month for five years. Depending on the price of Stock A from one month to the next, the number of shares each $1,000 injection can purchase will vary.

To illustrate, if the price of Stock A is $50 on March 1st, your $1,000 would purchase 20 shares. If the stock price drops to $45 on April 1st, your second $1,000 would buy 22.22 shares. And if the price goes up to $53 on May 1st, your third $1,000 would purchase 18.87 shares of Stock A. This would result in an average cost of $49.11.

What Is Dollar Cost Averaging (DCA)?

If you had enough cash flow to purchase $3,000 of stock on March 1st instead of using the DCA approach above, you would only hold 60 shares of Stock A with an average cost of $50. Perhaps if you had the vision that the price would fall, you could have waited until April 1st to invest the $3,000, but it is too difficult for most investors to foresee optimal entry points.

The objective of a dollar cost averaging strategy is to consistently invest and achieve a lower average price per share than if you were to try and time the market.

Reasons To Consider Dollar Cost Averaging

There’s no question that the stock market is unpredictable. Even if you read every investing book in the world and stay on top of all the latest news, it’s unlikely you would have the ability to time every one of your trades perfectly.

How much DCA could benefit your portfolio depends on your individual situation, the direction of the market, your risk preference and goals, asset allocation, and amount of disposable cash at hand.

A study by Vanguard found that dollar cost investing is inferior in performance to lump sum investing about two-thirds of the time. However, in their research they were focused on investors with large, readily available lump sums of money. In other words, this study was analyzing voluntary DCA, meaning the investors had the choice of keeping some of their cash liquid and deliberately distributing it over time.

This is in contrast to involuntary DCA when investors are not sitting on a pile of cash and utilize features like auto-deposits to make consistent investments on a set schedule using their current income such as someone investing $1,000 out of their paycheck every month.1

According to their research, if you have a large sum of money at hand that you want to invest but are concerned with minimizing downside risk, and also want to avoid the possibility of regret if you invest everything before a downturn in the market, then dollar cost averaging can be more beneficial than lump sum investing.

Investing Discipline Can Help Put Your Money To Work For You

That being said, many everyday investors are not sitting on a large pool of cash and do not prioritize investing and retirement savings. Based on a study of 20.6 million Americans’ individual retirement accounts, the Employee Benefit Research Institute reported that 41 percent of households 55-64 have zero retirement savings.2

A lot of people have a tendency to spend any leftover money in their bank accounts after all their bills are paid each month instead of investing for their retirement. In cases like these, using the disciplined trading approach of dollar cost averaging not only prevents them from procrastinating on their investing goals, it also helps them save for retirement and avoid wasteful spending.

Dollar cost averaging can also help investors who tend to be hesitant with investing and hoard cash out of fear or uncertainty. Having some cash on hand can provide peace of mind during volatile markets, but holding too much cash for too long can weigh down your portfolio’s return over time due to inflation. Plus, dollar cost averaging can help investors put their money into the market as quickly as possible on a consistent basis.

In addition, DCA is useful for less experienced investors that lack conviction or skill at finding optimal times of entry. Dollar cost averaging may also help minimize risk for investors in the event that prices continue to descend.3

Holding Cash Versus DCA During A Market Crash

Now that the 2008 financial crisis is behind us, have you ever wondered what your portfolio would look like if you had invested in a different way? Here’s a look at two hypothetical outcomes.

The S&P 500 peaked in October 2007 before the financial crisis set in. You’re probably thinking that month would not have been an optimal time to invest.

SP-500-performance-1

Source: Business Insider

The results of using dollar cost averaging versus holding cash might surprise you.

Scenario A: You invest $50 at the beginning of every month into an S&P 500 index fund starting in October 2007.

Result A: Your portfolio would be worth $7,066.62 at the start of January 2016.

Scenario B: You set aside $50 in cash at the beginning of every month starting in October 2007.

Result B: You would have accumulated $5,000 in cash.

This demonstrates how starting a DCA strategy even right before a market crash can be more profitable than not investing at all and just holding cash.

Holding Cash Versus DCA During A Market Crash

Source: Business Insider

Of course there are no guarantees when it comes investing. If you have a long-term focus and the fundamentals of the stock you are building a position in have not changed, dollar cost averaging can be a prudent strategy to deploy during both good times and bad.

Motif Makes It Easy To Invest Using Dollar Cost Averaging

Motif is excited to announce we recently rolled out the ability to set recurring transfers to and from your account so that you can better employ consistent investing strategies like dollar cost averaging into your favorite motifs or stocks.

Getting started with recurring transfers is easy. Simply log in to your Motif account and select “Transfer Money” from the “My Account” dropdown menu. Quickly setup a recurring deposit by indicating the frequency and duration. Learn more about setting up recurring transfers with Motif.

Don’t have an account at Motif yet? Opening an account is quick, easy, and free.

 

  1. Vanguard Research, “Dollar-Cost Averaging Just Means Taking Risk Later,” Vanguard, July 2012.
  2. Copland, Craig, “Individual Retirement Account Balances, Contributions, And Rollovers, 2013; With Longitudinal Results 2010-2013: The ERBI IRA Database,” Employee Benefit Research Institute, May 2015.
  3. Kiersz, Andy, “How to Invest in Stocks if You’re Convinced the Market Will Keep Crashing,” Business Insider, August 24, 2015.
    https://www.motifinvesting.com/?p=17729&preview=true
  1. Brian M.
    18 Feb at 8:22 pm

    Great post; many individual investors are scared of the volatility and uncertainty in market environments like the one we have been in for the past year. In situations like this, DCA can be a valuable tactic as a way to avoid sitting on the sidelines or making risky bets. I also think commission fees present a barrier to investors that would otherwise like to DCA. I wrote a post on this, “4 Ways to Dollar Cost Average on a Limited Budget”. Check it out at buildingthebank.com

    Reply
  2. Carl
    23 Feb at 8:04 am

    I use DCA in 3-6 month blocks when I’m freaked out about the market but still want to invest. Sticking to a schedule helps me stay active.

    Reply

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