Dollar-cost averaging (DCA) is not a failsafe measure. Like all investment strategies it has both positive and negative aspects.
Dollar-cost averaging: The Good
Dollar-cost averaging is an automated and disciplined investment strategy. It removes emotions from the investment process because you’re investing a fixed amount of money each month. As the price of an ETF or stock varies from month to month, you acquire the ETF or stock at an average price per share over the year. This has the effect of smoothing out the price you pay for your investment over time. It also allows you to purchase more shares when the price is low and fewer shares when the price is high since the dollar amount of money invested stays the same each month.
Another added benefit: Getting you in the market and earning a return instead of nervously waiting for just the right moment to get in. Waiting increases the risk of never getting invested.
Dollar-cost averaging: The Negative
Negative aspects of dollar-cost averaging include what experts call the cash drag, or the length of time investors hold cash that does not earn a return, because it’s not in the market. The absence of a return on uninvested cash means your money can actually lose value over time due to inflation.
Additionally, experts argue that dollar-cost averaging is just a form of taking the same market risk later for no reason. They argue that if investors are ultimately comfortable with their end assets allocation, say 60% in stock and 40% in bonds, then dollar-cost averaging only serves to delay the process of being fully invested without providing any substantial additional benefits.
In the long run, dollar-cost averaging is most effective when making monthly investments into an investment vehicle like a Roth IRA from a cash flow stream, such as a monthly salary. In this case, you do not actually have the option of lump-sum investing, except to save the cash and then invest it all at once.
Saving cash and investing it as a lump sum risks the worst of both worlds. It keeps the investor out of the market for a year while funds are built up. It also risks the main mistake dollar-cost averaging is designed to prevent, which is making an ill-timed investment all at once, at an unfavorable market price.
|Pros of Using Dollar-Cost Averaging||Cons of Using Dollar-Cost Averaging|
|Stable investment schedule that does not require a great deal of monitoring Cash drag: leaves the investor in cash longer than lump-sum investing||Cash drag: leaves the investor in cash longer than lump-sum investing|
|Puts the investor in the market instead of nervously waiting for the right time to invest||Investor can miss out on positive returns in a rising market by prolonging the investment process|
|Takes the emotion out of investing and limits risk of mistimed investments||Still a form of market timing by delaying or drawing out the final asset allocation (e.g. 60% stocks and 40% bonds)|
|Accounts for market volatility by diversifying the price-per-share||Studies suggest lump-sum investing provides higher average returns than DCA over long term investment horizons|
|Easy to implement||DCA does not reduce market risk, it just means taking the same market risk later|