Is Dollar-Cost Averaging Worth It?

Dollar-Cost Averaging

Dollar-cost averaging is an investment strategy that can really save your neck in the right circumstances. But it’s a strategy that I avoid when I can. Today I’ll go over what dollar-cost averaging is, why it works, and why it (usually) isn’t right for me.

What is Dollar-Cost Averaging?

Even though I think the stock market is a great place to invest, it has a pretty big weakness: Volatility. It goes up and it goes down. Sometimes the swings can be jarring. And as bad as the market as a whole is, individual stocks are worse.

One area where the market’s volatility can work against you is when prices fall right after you invest a large amount. Let’s consider an example. Imagine you have $5,000 to invest and you buy into an index fund at $100 per share. But next month, the price drops to $70 a share:

MonthShare PriceSharesInvestment Value

In this example, your investment has quickly lost $1,500. It’s not quite as bad as it looks, the loss is only a “paper loss.” In other words, you only actually lose money if you sell. The deeper problem is the opportunity cost. Take a look at those 50 shares that you probably glossed over in the last table. Then compare that to what would have happened if you had invested in month two:

MonthShare PriceSharesInvestment Value

If you had just waited a month, you could have had more than 70 shares instead of 50! Let’s pretend that at the time you eventually sell, the shares have gone up from $100 a share to $1,000 a share. Those extra 21.43 shares would have been worth $21,430. Ouch!

How can you avoid tragedies like this? Why, with Dollar-cost averaging of course.

Why Does Dollar-Cost Averaging Work?

Dollar-cost averaging spreads out your investment, forcing you to buy fewer shares when the price goes up, but allowing you to buy more shares when the price goes down. It flips the normal script on its head. Normally, a drop in price after you invest a lump sum is a bad thing. But if you are dollar-cost averaging, you only invested part of your money. Your next installment will take advantage of the lower price.

Stated simply, dollar-cost averaging gets better the more the price drops in the short term. So in this way, it’s the opposite of lump-sum investing.

To see the benefits in action, let’s work though an example:

$5,000 Spread Over 5 Months—Price Goes Down

Earlier, we looked at a situation where you invested $5,000 all at once only to watch the share price drop from $100 to $70 the next month. Let’s pretend that instead of investing all at once, you dollar-cost averaged $5,000 in equal installments of $1,000 for 5 months:

MonthAmount InvestedShare PriceShares Purchased

Remember, if you had put all $5,000 in at $100 a share, you would have ended up with 50 shares. In this particular example, you end up with nearly 72 shares. Granted, this is an example I made up and purposely stacked to be favorable to dollar-cost averaging, but this illustrates how spreading your investment out can pay off if the price drops.

But now let’s consider a couple of counter-examples.

$5,000 Spread Over 5 Months—Price Goes Up

When the price goes down, it’s better to spread out your investment. But when the price goes up, it’s better to just invest all at once as soon as possible.

MonthAmount InvestedShare PriceShares Purchased

Instead of just going in an buying your 50 shares, you wait, spread it out, and end up getting fewer shares!

Let’s look at one last example:

$5,000 Spread Over 10 Months

Part of the problem with dollar-cost averaging is that it isn’t obvious how you should spread out your investment. What’s worse, it actually matters. It isn’t enough to guess right that the price is going to go down, you have to time it so that you’re done investing before it goes up too much.

To illustrate this, let’s take the same example as before where the price dropped in the first five months. Except this time, we’re going to spread out the investment over 10 months instead of five, and the price is going to rebound hard:

MonthAmount InvestedShare PriceShares Purchased

Not only did we miss the opportunity to pick up more than 70 shares by spreading our investment, but we somehow ended up with fewer than the 50 shares we would have ended up with if we had just put all our money in all at once.

You could argue that we have very nearly as many shares despite an unrealistic surge in price, and that’s true. But this is just an example where I picked the numbers and the price dropping from $100 to $40 was probably unrealistic anyway.

The point is that you don’t know which way the price is going to go and how much. If the price drops, you might come out ahead dollar-cost averaging, but you need to get most of your money invested before the price rebounds too much.

Why Do I Try to Avoid Dollar-Cost Averaging?

First of all, let’s go back to basics. Why are we investing in the stock market in the first place?

The short answer is because we’re expecting the market to go up.

So if dollar-cost averaging is worse when the market goes up and we’re only investing because we expect the market to go up, doesn’t that almost give us our answer?

You could respond that even if we expect the market to go up in the long-term, couldn’t it still make sense to use dollar cost-averaging to hedge against short-term volatility?

Yes, but in the short-term stocks go up more often than they go down. In the 95 full years since 1928 (the first year with S&P data), the market has had 69 years with a positive return against just 26 years with a negative return. That’s 72.6% of the time that the market goes up. It goes up nearly three out of every four years.

You could argue that a year is too long of a time period. Fair enough. But when you look at the months it’s the same story, there are more months where the market goes up than when it goes down.

Why I can’t avoid dollar-cost averaging altogether (and why you probably can’t either)

So with that said, you might think that I don’t engage in dollar-cost averaging. Actually, most of the money I have invested was dollar-cost averaged.

How do I explain this paradox? Well, it’s pretty simple really. If I could invest more now, I would but I can’t. My income and expenses operate on a monthly schedule. I can’t just decide to devote my first several paychecks of the year to investing because how would I pay my bills those months?

So like most people, I have money automatically taken from my paycheck and deposited into my 401k. I also have money automatically withdrawn from my bank and invested into the stock market in an IRA. When you think about it, those are both forms of dollar-cost averaging.

The nice thing is that if the market crashes (and it will crash), I’ll be forced to “buy the dip.” When you dollar-cost average and are young, market crashes actually help instead of hurt because they are an opportunity to buy stocks at a discount.

The Factors That Make Dollar-Cost Averaging More Attractive

As far as I can see, there are three factors that make dollar-cost averaging far more attractive than normal:

If it helps you overcome the psychological hurdle of investing

For a lot of people investing can be intimidating. Especially if you have a large lump sum to invest. If you find yourself terrified at the prospect of a market crash immediately after you put your money in, consider dollar-cost averaging. Whatever helps you get your money in is going to be better in the long run than stalling because you’re scared to pull the trigger.

If your asset is especially volatile

The stock market is already decently volatile. Individual stocks are even more volatile than the market as a whole. Certain stocks are even more volatile than others.

If you are investing in an individual stock that you plan on holding long-term but think there is some short-term uncertainty, dollar-cost averaging could be the right move.

This is one of the reasons why dollar-cost averaging doesn’t mesh with my investing style. I’m a passive, index fund investor. I don’t play the picking individual stocks game.

If you have a short time horizon

Right now, I have a pretty long time horizon. I’m in my 30’s and probably won’t be taking money out until my 60’s. It’s hard to imagine I’ll be forced to sell the shares I’m buying now at a loss.

But if you have a shorter time horizon, it’s more of a risk.

Dollar-cost averaging will certainly help here, but it might not even be enough on its own. Chances are, you shouldn’t have all your investment money in stocks if you are investing for the short-term. To protect yourself, you need to master the art of asset allocation.

If it’s helpful, I wrote a lengthy post on asset allocation that I consider my “investing 201” class (the “101 class” is the classic post Investing the Simple Way):

How Much Does Dollar-Cost Averaging Really Matter?

We’ve already seen that maximizing the number of shares that you own of a stock or index can pay off over time. At a future price of $100, you’ll have an extra $100 for each additional share you had been able to purchase. At a share price of $1,000, you would have $20,000 more in your portfolio if you had been able to squeeze out 20 extra shares.

So it matters, but how much?

Let’s take a look at this graph, published on Wikipedia, showing the changes in price in the S&P 500 from 1950 to 2016:

Image By Overjive – Own work, CC BY-SA 4.0, Wikimedia Commons

And by the way, when I checked this morning, the S&P was at nearly $4,000, almost double what it is in this chart.

If you had dollar-cost averaged in 1950, it could have helped. But clearly the important thing was to just get your money invested. Squeezing out a few additional shares would have paid off at a rate of $4k per share if you sold today. But leaving your money invested from 1950 until now would have resulted in your investment multiplying by a factor of what looks like about 40.

Time in the market vs Timing the market

So the big key is to get invested and to stay invested. When you think about it, dollar-cost averaging is a form of trying to time the market. You think the market is about to go down and you’re trying to take advantage of the dip. The problem is, you’re making a bet on something that only happens about a quarter of the time. It can work out, but the odds are against you.

Final Thoughts

To me, the decision whether or not to dollar-cost average is similar to the decision of whether to invest in a traditional IRA or a Roth. Yes it can matter and in hindsight there was probably a right choice, but there’s no way of knowing ahead of time which will be better. And in both cases there’s a more important factor to think about: You need to just get your money in the market.

I’ve written before about the using outcome report card to make decisions. One of the implications is that if you’re choosing between one option that will result in an A+ outcome and one option that will result in a solid A but you don’t know which is which, the act of picking and taking action is more important than which option you pick.

If you’re interested in that approach, you can read more here:

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