There are many misconceptions about dollar-cost averaging (DCA) as an investment investment strategy. We took a look at some myths to help you understand how to implement it, how effective it is, and what it’s intended to achieve.
Myth 1: Brokerage fees do not affect the strategy
For dollar cost averaging to be effective, it’s critical to invest a fixed amount of money each month. But high brokerage fees can significantly reduce this sum of money over a longer period of time. Trading commissions or other fees divert money away from the investment process, so finding a low cost way to conduct the regularly scheduled trading required when implementing the DCA strategy is key to its success.
As a quick example, let’s say you’re investing in a Roth IRA retirement account with a 20 year investment horizon, funded with monthly instalments from your paycheck. So if trading fees on average are around $4.95 per trade, over the course of 20 years this is $1,188 in trading commissions (assuming only one trade per month). This is more than 1 month’s funding put toward your strategy. Costs can be as high as $14.95 per trade, nearly three times the average, which would eat into your investment performance even more.
Myth 2: Dollar-Cost Averaging is less risky than lump-sum investing
Some investors believe that using DCA reduces market risk. In reality this is not the case. Once fully invested, you are exposed to the same market fluctuations as investors who put their money in the market all at once. The eventual goal is to be fully invested at our target asset allocation, so using DCA is a way to push market risk into the future, but is not actually a way to eliminate it altogether.
DCA is not a risk management tool, rather it is an investment strategy designed to diversify the price-per-share you’re paying over time. More than anything it is intended to remove the emotional aspect of investing by making sure investors put money in the market regularly . It also has the added benefit of allowing you to acquire more shares when prices dip, and fewer shares when prices rise, which can give you a sense that you’re getting a better deal when a stock price is temporarily down.
Myth 3: Dollar-Cost Averaging prevents market timing
You might use DCA because you have no choice. For example, you might get a paycheck once a month, and use DCA as a way to put a portion of this money in the market month after month. Other investors may receive a large pool of money, for example through an inheritance, and need to decide the best way to put this money in the market. They may be concerned about investing at the wrong time, and therefore adopt DCA as a way to prevent guessing the right time to jump in. But using DCA is in itself a form of market timing. Investors are delaying the investment process and putting off the time when they will reach their targeted asset allocation by holding on to cash for an extended period.
DCA may feel like it removes market timing, but in reality if you’re comfortable with your targeted asset allocation, you could just as easily put the money in the market all at once. DCA is intended to remove the emotion from the investment process. DCA is an effective strategy to put money in the market gradually, and is potentially better than not investing at all for fear of buying at the wrong price. But you need to be mindful that the trade off with DCA investing is holding on to your cash, with little or no return, for several months while funds are deployed gradually. This can potentially drag on investment performance in a rising market.
Myth 4: Dollar-Cost Averaging is difficult and expensive to apply
DCA is a passive investment strategy whose strength lies in its ability to take the emotion out of investing. Investors most often use DCA when they’re concerned about the potential risks of investing a sum of money all at once. It is also a good way for investors to be disciplined about putting money to work in the market and can reduce emotions that often go with investing. This approach makes DCA an easy strategy to apply.
Some investors may feel that DCA is an expensive strategy because it requires you to place regular–usually monthly–trades that require a trading fee each time. With so many low-cost brokers on the market, some with commissions for less than $5, the cost of DCA are small compared to not being in the market at all. Opportunity costs that accumulate while the investor nervously waits for the right time to get involved are, on average, more than the brokerage fees required to implement the strategy.
Myth 5: You need a financial professional to apply Dollar-Cost Averaging effectively
If you’re a first- time investor, you might be unsure of the best way to invest and you might be afraid of making tactical mistakes that will cost you money. Using a financial professional may be one way to take the responsibility off your shoulders, but this is usually an expensive approach with questionable results. Some studies suggest returns from active investing by financial professionals is inferior to passive investment strategies like DCA over long periods of time. DCA is a way to take the stress out of investing by putting a fixed amount of money in the market each month. A first-time investor can do this without the help or expense of a professional investor and could achieve superior long-term investment returns compared to an active investment manager.