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When you have a large sum of money to invest, you have two choices. Either you invest it at once, or you cut it in smaller sums, and you invest it over a longer period. The latter option is called Dollar Cost Averaging (DCA).
Most people will tell you that you should always Dollar Cost Average your investments. However, I believe that investing a lump sum is always better than using DCA.
In this post, we are going to see what DCA is precisely and what are its advantages and downsides. With that done, we will know how to invest a lump sum.
We are also going to talk about Continuous Investing. Continuous Investing when you invest your savings every month as soon as you have it available. Some people call this DCA, but I think this is not accurate. These are two different things. One is excellent, but the other is not.
Dollar Cost Averaging (DCA)
Dollar Cost Averaging (DCA) is the idea of investing a large sum of money over a more extended period. DCA will effectively average the price of what you are buying over a longer period. Hence the name of dollar cost averaging your purchase.
We can take an example. Let’s say you got 60’000 USD to invest. You want to invest it in the Vanguard Total World ETF (VT), the ETF that we already talked a lot about.
You could invest it at once today in the stock market. But you are afraid that the market will suddenly drop. And, indeed, the market can quickly lose a few percents in one day. And can drop up to 40% in a few months. Such a drop does not happen often, but it can happen. And you are afraid that just after you invested your big sum, the market will drop a lot.
So, instead of investing it at once, you decide to Dollar Cost Average your purchase of VT. You cut your sum into 12 parts of 5000 USD. And you choose to invest one part every month for one year.
So if the price of VT tanks shortly after you made your first investment, you will have saved a lot of money since the average price of your investments will be lower than it would have been.
DCA introduces another risk
You have eliminated one significant risk. However, you have just introduced a new significant risk. If the market is going up during the time you are dollar cost averaging, the average price will significantly increase. You have traded one risk for another.
It remains to see which risk is more significant.
In practice, the second risk is greater. The stock market, on average, is going up. You can easily see that on the graph of the S&P 500 over more than half a decade. So, every year the stock market has more chances to go up than down. From a probability point of view, the risk introduced by DCA has more effect than the risk it fixes.
For instance, in the last 100 years, the Dow Jones Industrial Average (DJIA) was up 70% of the years. So, the DJIA is twice more likely to go up than to go down. Thus you are increasing the risks in your portfolio by using DCA.
Downsides of DCA
First of all, when you dollar-cost average your purchase, you are betting against the market. However, there is a higher probability that the market will go up rather than down. By dollar cost averaging, you are increasing your risks.
All the cash that is waiting to be invested is incurring some opportunity cost. First of all, it will not generate any dividends. On average, a good stock market index will have a dividend yield of about 2%. You are missing on the dividends. And you are also increasing the risk of inflation.
One small disadvantage of DCA is that you will likely increase the transaction fees for your investment. Generally, most brokers have a small flat fee and a percentage fee. If you invest twelve times instead of once, you will pay 12 times more transaction fees. These fees should not be a lot of money, but this is still some wasted money.
DCA will only protect you from the risk of the stock going down during the period of DCA. Nothing prevents the market from plunging the day after you have finished your DCA investment.
DCA is a short-term strategy! If you want to invest for the long-term, it is not a good strategy. Most of the time, it will not work.
And talking about the period, you still have to choose the period during which you want to dollar cost average your investment. A typical time frame is one year. But you could choose to invest for two years or only six months. Choosing the optimal period for DCA is impossible. Trying to do so is market timing.
The entire idea of DCA is very close to market timing. If you have doubts as to whether the market will go up, you are already timing the market. And we have discussed it previously, timing the market is a loser’s game. There is no way to predict the market. We can only base our decisions on the facts that we already have. These facts are more than one hundred years of stock market data. And these have shown that generally, the stock market is going up. Therefore, you should bet on the market going up, not down.
Finally, by holding a lot of cash, you are also messing with your asset allocation. When you started investing, you decided on an asset allocation that suited you. For instance, you may have decided to invest 80% in stocks and 20% in bonds. But now, you have a large amount of cash. Maybe you have 40% in stocks, 10% in bonds, and 50% in cash now. And your asset allocation will only be balanced once you are done investing it.
Value Averaging is an alternative way to do dollar-cost averaging. Instead of investing the same amount every month, you will invest based on the current value of your shares.
Let’s take the same example as before. You want to invest 60’000 USD in 12 months. In the first month, you will invest 5000 USD as with DCA. However, in the second month, you will invest an amount so that the value of your shares reach 10’000 USD. For example, if the shares went down in value to 4500, you will buy 5500 USD to bring it back to 10’000. If the shares are then going up the next month and reach 11’000 USD, you will have to invest 4000 USD.
So instead of having a fixed investment each month, you have a fixed goal.
Some people like Value Averaging because it avoids investing too much when the market is going up and invest more when the market is going down.
However, it has some important downsides. If the market goes down a lot during the year, you will have to invest much more than you planned. If you invested during the financial crisis of 2008, you would have had to invest more than 80’000 USD in bringing back the value to 60’000 USD. So where are you going to find the extra 20’000 USD?
And on the contrary, if the market is going very well, you may have to invest less than you wanted. Then, what are you going to do with the extra money?
I think that Value Averaging is strictly worse than DCA. It has fewer advantages and more disadvantages. It is too complicated and incurs too many risks.
How to invest a Lump Sum?
Now that we have seen that DCA is mostly a bad idea, it is straightforward to know how to invest a lump sum.
You should invest a lump as soon as possible and at once. You need to know your target allocation and use the lump sum to make sure your portfolio is balanced. If you need bonds, buy bonds. If you need stocks, buy stocks. And if you need both, just buy both! It is an excellent time to balance your portfolio correctly.
Continuous Investing is not DCA
Now, you may be thinking: what am I supposed to do with my savings every month?
You need to invest it as soon as you get it! Invest your savings every month could be considered some form of Dollar Cost Averaging. However, it is unavoidable. And there is a lot of posts talking about that and saying this is Dollar Cost Averaging. I think that both concepts should be separated. We can call this Continuous Investing.
If you do not invest it directly but wait, for instance, until you have one year or even one-quarter of savings, you are going to increase your risks significantly.
You cannot reduce the risks of your monthly investing. Once a month, you should invest your savings. You should do that regardless of the price. Over a very long period, this will save you money to invest frequently since you will buy when the price is high, and you will also buy when the price is low, giving you a better average than if you invest only once a year.
This form of DCA is unavoidable and is the recommended way of investing! It is great to invest your savings each month. You need to invest continuously.
Why are people recommending DCA?
All over the internet, almost everybody is recommending Dollar-Cost-Averaging over Lump Sum Investing.
I believe the main reason is that DCA makes people feel better. If you invest over several months and the market is going down, you will feel better that you did not invest too much the first time. Moreover, you will also feel better about buying shares at a discount.
It all comes down to the fact that people are much more afraid of a loss than they are happy with a return. Most people will feel a bigger impact with a loss of 10% than with a profit of 10%. This fact has been shown many times already.
People prefer avoiding a small loss than staying for the long-term and taking a more significant return. Therefore, people recommend DCA not to feel bad about investments.
But I think this is wrong. Most people are investing for the long-term. And therefore, it is better to maximize long-term gains. Even if you feel bad for one year or two years, you should be able to weather it.
What is Dollar Cost Averaging (DCA)?
Dollar Cost Averaging (DCA) is an investing technique where you invest a sum of money over a longer period. The larger sum is split into smaller portions and invested as such.
What is Value Averaging?
Value Averaging is an alternative to Dollar Cost Averaging (DCA). Instead of investing the same amount every time, you invest based on the current value of your shares.
What are the downsides of Dollar Cost Averaging (DCA)?
When you dollar cost average an investment, you are betting against the market. But on average, the market is going up. This means you are making the wrong bet.
What are the advantages of Dollar Cost Averaging (DCA)?
Dollar Cost Averaging (DCA) protects you against a drop in the market happening directly after you started investing.
I do not advise to Dollar Cost Average any of your investment. You should stick to your asset allocation and invest money when you have it. It is part of my Investor Policy Statement not to use DCA.
If you are investing for the long-term and you have a large sum of money to invest, the best course of action is simply to invest it. Dollar Cost Averaging the investment will simply increase your risks of losing out on returns. And do not forget to invest according to your asset allocation.
Now, if you want to invest using DCA, just do it. If it makes you feel more comfortable. It is an excellent technique to cut some emotions out of investing. But you should not let your emotions choose your investing strategy.
But you should still invest your savings monthly. Continuous Investing is not the same as Dollar Cost Averaging. There are too many articles on the internet that mix the two concepts. Continuous Investing is great, DCA is not great!
While it is not a very popular opinion, I am not at all the only one that thinks like this. For instance, JL Collins talked about why he does not like DCA.
What about you? What do you think of DCA? Do you use it?