Web Wealth: Dollar-cost averaging
When you are new to investing or in search of a disciplined way to salt away funds, try the method called dollar-cost averaging, or DCA. Here are some pointers, and caveats.
When you are new to investing or in search of a disciplined way to salt away funds, try the method called dollar-cost averaging, or DCA. Here are some pointers, and caveats.
Investopedia.com explains the basics: "Dollar-cost averaging is carried out simply by investing a fixed dollar amount into your mutual fund (or other investment instrument) at predetermined intervals." But why? "It's a strategic way to invest because you buy more shares when the cost is low, so you get an average cost per share over time, meaning you don't have to invest the time and effort to monitor market movements and strategically time your investments."
Investing at regular intervals through dollar-cost averaging is a "technique that drastically reduces market risk," says Joshua Kennon in the About.com area for beginning investors. Kennon outlines three steps for getting started: Make a realistic determination of how much money you can afford to invest monthly; select an investment, such as a mutual fund that holds shares of many companies, and start investing automatically from your paycheck or from a brokerage account.
What if you've got a lump sum of money to invest - say, from a bonus? Should you invest it all at once (called lump-sum investing), or in stages using dollar-cost averaging? Many advisers say to do the latter. But this post at Moneychimp.com says that's not necessarily the way to go. It provides a calculator to let you experiment. "Each strategy wins at least some of the time, but after a few runs you'll see that DCA is the statistical 'dog,' losing about two times out of three," the post concludes.
Some articles cite this research paper from Malvern-based Vanguard Group to raise the caution flag on splitting up a lump sum for dollar-cost averaging. "On average, we find that an LSI [lump-sum investing] approach has outperformed a DCA approach approximately two-thirds of the time," says the paper. The reason is simple: Over the study period - and for much of recent market history - "the returns of stocks and bonds exceeded that of cash."
Of course, if you don't have a nice old aunt who has died and left you $1 million, you'll want to dollar-cost average, says Vanguard founder John Bogle in this video at YouTube. "It's a way of eliminating, to the maximum extent possible, the vagaries of the stock market," which in the short term goes up and down "for no explainable reason," he says. DCA is the answer "under those circumstances, and those circumstances are the circumstances that will apply to probably 95 percent of all investors."