First, let’s get some definitions out of the way. Dollar-cost averaging (DCA) refers to an investment strategy of investing a fixed amount of money over a time period (say 1 year). There are two types of DCA:
- Voluntary DCA implies you have a liquid amount of cash to invest, but are intentionally parceling it out over time. The cash will (you hope) be earning interest while it’s not invested.
- Involuntary DCA generally refers to auto-deposits set up to invest as you earn money. Your purchase points are at different points, but you did not have any period of sitting in cash.
The big difference between these two is how long you were sitting on cash, rather than investing it in a portfolio. 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.
Ok, gimme the answer already smartypants!
From a purely unemotional investment strategy perspective, because the expected total return of markets is positive, it makes sense to invest immediately, and not worry about timing the market. It’s important to remember that while the price of stocks may go up or down, they are usually paying about 2% in dividends. Thus your price return can be flat, but your total return (price return + dividend return) is still up. So if you wait, you’ll probably have a lower total return, though not by a large amount.
Sidenote: One valid investment strategy reason to practice dollar-cost averaging is because you have a weak view that the market will be going down in the near/short-term. Otherwise, it’s best to just invest the money, and not worry about timing it.
However, there are some very nice psychological benefits to dollar-cost averaging:
- it diversifies your purchase price, which makes you less susceptible to the Disposition Effect
- it likewise reduces your anxiety that you have bought “at the top”, and thus makes you less disposed to attempt market-timing and pull out after being invested.
- it gives you a concrete plan for moving out of cash. The move from “safe” to “higher risk/return” is an uncomfortable one, and often people want to feel that they’re doing it in a controlled manner. Having a clear plan to do it over a period of time is better than not doing it at all.
With those points in mind, it actually can be more rational to voluntarily dollar-cost average. After all, it’s better to invest slower and more comfortably, than never invest at all.
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This article was published on January 29, 2013