Dollar Cost Averaging Works If You Let It
I’ve been a proponent of the investment technique called Dollar Cost Averaging (we’ll abbreviate it DCA for this article). DCA is when, instead of putting a lump of money into your investments, you split that lump up into equal amounts and invest at fixed intervals.
For instance, let’s say that Uncle Jack left you $300,000. You’re worried that the mutual fund you use might go down. So instead of putting all $300,000 in at once, you divide it into thirty $10,000 blocks invested monthly over the next 2-1/2 years.
By investing at set intervals you keep from letting the market’s emotions control you. By investing set amounts you’ll tend to buy more shares when the market is down and fewer shares when it is up. In fact, if the market zigzags you’ll actually pick up your shares at less than the average cost during that time.
That’s the way it’s supposed to work. Here’s what actually happens. You start the DCA process and the market drops like a rock (sound familiar?), so you stop the DCA investments because you don’t want to buy shares if all they are going to do is go down. When you are sure the market is going back up, you restart the DCA. If the market goes up rapidly, you end up dumping in all that you’d planned to invest at once so that you don’t miss ‘certain’ gains.
Let’s review: In theory, DCA helps you by mechanizing your trades so that emotions don’t take over. You’ll end up buying more shares if the market is down and less if the market is up. Thus you’ll, on average, pay less for your investment and generate greater profits.
In reality, you let the emotions of the market turn off your mechanical DCA strategy. You buy fewer shares when the market is down, more shares when the market is up and a lot more shares when the market is up ridiculously. This means you’ll, on average, pay more for your investment and generate fewer profits.
Don’t do that.
Another time honored way to getting a lump of money in the market is to just put the lump of money in the market. “Oh, but it might go down,” you say. First, you’re likely only thinking this if the market already went down—a great time to dump a lump of money into it. Second, the market will, eventually, go up.
You could, of course, divine the future and wait with your lump of cash until the market is about to go up and then put it all in. Good luck with that. There is a two-thirds chance that a year after you could have put the money in the market, it is already up and you missed it.
So, if you’ve been given a lot of money and are wondering when to invest it, go ahead and Dollar Cost Average or go ahead and put the lump sum all in at once. Just don’t try to second guess the market in either case. It seldom comes out well.
This article was published under the title "Patience needed for DCA investing" in the Wichita Falls Times Record News on September 18, 2011.