What is Dollar-Cost Averaging?
Although it’s not always the most optimal investment strategy, choosing to dollar-cost average into the market has behavioral and psychological benefits that may help you over the long run.
Dollar-cost averaging (DCA) is the practice of regularly investing a fixed amount of money over a period of time, regardless of market activity.
For example, if you choose to invest $100 on the 15th of the month, every month for 1 year, you would be implementing the investment strategy of dollar-cost averaging. You don’t vary the dollar amount you choose to invest ($100), or the timing of the investment (on the 15th of each month), based on market activity.
Types of Dollar-Cost Averaging
There are two types of dollar-cost averaging: voluntary and involuntary.
Voluntary DCA is when you have a specific amount of cash to invest, but are choosing to parcel it out over a period of time, rather than investing it all at once.
Involuntary DCA is when your ability to invest depends on when you have the money to do so. Perhaps you set up auto-deposits, so that you can invest as you earn more money over time with each paycheck.
The major difference between these two types of DCA is that involuntary DCA implies that you could not have invested sooner, while voluntary DCA is an investment strategy where you could have, but chose not to.
Real Life Example
Let’s pretend you have $1,200 sitting in cash that you can invest right now. You choose to invest that $1,200 by investing $100 per month for a period of one year. This would be an example of voluntary DCA.
Now, let’s pretend you don’t have any money to invest right now, but through your paychecks you earn $100 per month that you could invest. You invest $100 per month for a period of one year. This is an example of involuntary DCA.
Should You Dollar-Cost Average?
This question really only applies to voluntary DCA and not involuntary DCA. If you don’t have any money sitting around to invest, then you’ll need to wait until you have the money to invest. For involuntary DCA, the choice becomes whether to invest that money as soon as you earn it, or to let that money build up over time so that you can invest the entire balance.
An optimal strategy for involuntary DCA is to schedule auto-deposits as soon as you get paid.
If you do have money sitting around to invest, the question then becomes, should you invest it all right away, or should you DCA it into the market over time? There are a couple of answers to this question.
The Head vs The Heart
The expected total return of markets is positive over time. Therefore, from a purely unemotional investment strategy perspective, it makes sense to invest your cash immediately and not DCA into the market. Studies show that a lump-sum investment will outperform DCA roughly two-thirds of the time and will consistently outperform DCA across global markets.
Yet, we all know that leading with the head is easier said than done. Luckily, following one's heart can come with its own set of benefits. Since DCA is a fixed rule, independent of market performance, it is unemotional, diversifies your purchase price, and makes you less susceptible to the counterproductive behaviors people often have when investing.
More specifically, DCA can make you less susceptible to the disposition effect, which is the tendency to sell assets that have increased in value, while keeping assets that have dropped in value. People significantly dislike losing more than they like winning, which is more formally known as loss aversion. This goes hand in hand with helping to reduce your susceptibility to anchoring bias, which is when you attach yourself to an irrelevant stock price and begin making investment decisions based on that irrelevant stock price at a later date.
Additionally, DCA can prevent you from trying to time the market—which is generally a losing investment strategy over the long run. It also minimizes your chances of feeling regret and may reduce any potential anxiety that you “bought in at the top.”
Maybe most important of all, DCA can help you establish good investment habits. After all, choosing to DCA into the market is better than never investing your cash at all.
Make A Decision
To recap, if you have a pile of cash sitting around to invest, studies show that investing it all right away is the optimal decision the majority of the time. However, choosing to voluntarily DCA into the market has many behavioral and psychological benefits that can have a positive impact on your investing behavior. The most important thing is picking your approach and getting started. It’s better than doing nothing and leaving your cash out of the market completely.