One of the biggest fears of any new or seasoned investor is . . . . . .
. . . . . . . losing money. This fear can inhibit some people from ever investing at all. It might also lead to selling preemptively or opting for a lower-risk investment option. To minimize the fear of losing money, investors sometimes choose a risk-reduction strategy, such as Dollar Cost Averaging (DCA).
The majority of academic research has shown that while dollar-cost averaging may help to manage risk, on average, it can reduce returns (and therefore might be considered inferior to lump-sum investing). However, the popularity of DCA remains high among practitioners and the investing public.
Given that research has shown that the pain of losses is more severe than the joy of gains for investors1, risk-averse investors may prefer to dollar cost average to minimize the potential regret of not doing so and seeing markets decline shortly after that.
What is DCA?
DCA is an investment tactic in which a fixed amount of money is invested regularly. One of the most common examples of DCA is investing in an employer-sponsored retirement plan, like a 401K, 403B, or Simple IRA. The intended goal of DCA is to provide the investor with a lower average cost of shares over time. Since the investment amount will be roughly the same at each interval, the idea is that more shares will be purchased when the price is low, while fewer will be purchased when the price is higher.
Those who support DCA use claim it can provide a lower average purchase price for a risky asset. Purchases of assets (that are higher risk) with DCA when prices are declining might help provide better returns than lump-sum investing.
What are the Proposed Benefits of DCA?
By only investing a portion of your lump sum, price drops will not impact your portfolio as heavily had you invested a more significant amount of your entire sum. In addition, dollar-cost averaging is meant to mitigate the risks involved in lump-sum investing. For example, an investor could face major losses in portfolio value if the market crashes or prices fall drastically.2 Risk-aversive individuals may, therefore, prefer to use DCA.
Market fluctuations and losses can significantly affect an individual’s emotional well-being. Further, emotional responses to these ebbs and flows, such as overconfidence or panic, can affect future investment decisions.3 Since only part of a sum is exposed to the market; losses may not be as drastic. Therefore, many individuals may experience a more muted emotional reaction than if all of their sums were affected, decreasing the likelihood of making emotionally-driven investment decisions in the future.2
As such, DCA may be a good option for those looking to minimize the impact of emotion on their investment choices.
What are the Critiques of DCA?
Missing Out On Gains
When employing dollar-cost averaging, portions of your money sit uninvested. The main argument against DCA is that these portions are not given the chance to accumulate any return at all. As a result, some investors and financial professionals may prefer another strategy such as lump-sum investing, which exposes a more significant portion of your funds to the market.
Lump-Sum Investing vs. DCA
In lump-sum investing, a larger portion of your money is given the chance to make gains sooner rather than later. However, investing a significant amount of your money also means that you may experience more pronounced unrealized losses if investments experience a loss in value. Over time, however, if you do not sell and therefore do not realize those losses, you can possibly make up that drop in value. This long-term thinking also supports the idea behind dollar-cost averaging. Ultimately, the decision to use either tactic will depend on your unique situation.
When to Consider Using DCA
Investors might choose to employ dollar-cost averaging for various reasons, including for investments that are historically more volatile. DCA is also a way to potentially regulate emotional responses. Dollar-cost averaging might be used in the following circumstances:
- Volatile investments
- Other long-term investments, such as 401(k)’s or IRA’s
- A time in life where any volatility is not feasible and may cause immediate ramifications (i.e., nearing retirement)
- Individuals who are risk-aversive
- Individuals who do not have the funds for a lump-sum investment
The alleged benefit of dollar-cost averaging is that it takes advantage of the unpredictability of the market and intends to lower the average cost of your shares as a result. When choosing how to invest, it is wise to seek the counsel of a financial advisor who can help you make the best choice for your circumstances and future goals.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.