Q&A: Dollar Cost Averaging
By Ric EdelmanOctober 2011
Question: I don’t think I fully understand the concept of dollar cost averaging. Can you explain?
Ric: Sure. With dollar cost averaging, you invest a certain amount of money at a certain interval — say, $100 per month. The amount and interval don’t matter. Being consistent does. To make it work, you must invest into something volatile, where the price per share changes often. Dollar cost averaging into a savings account doesn’t work; doing so into the stock market does.
Here’s why: Say you invest $100 into an investment that costs $10 per share. Next month, you get another $100 and you invest it, but the share price is now just $5. In the first month, you bought 10 shares, and in the second month you bought 20 shares, for a total of 30 shares. The average price that you paid is $7.50 — but the average cost of those shares is just $6.67 — thanks to dollar cost averaging.
Get it? Basic arithmetic shows that you buy fewer shares at higher prices, and more shares at lower prices. The result: a highly cost-efficient way of accumulating shares. This is why we strongly encourage our clients to invest on a regular basis. Those who have been doing so over the past 10 years have made a lot of money, even though the stock market itself hasn’t grown at all!
Here’s an important point, though: you should not use DCA when you have a lump sum to invest. Instead, you should invest your lump sum all at once.
Here’s why. Over long periods, investments tend to rise in price. That means you’re likely better off investing sooner rather than later.
Consider the alternative of investing slowly over time. Say you invest 10% of your money each month. It will take you 10 months to be fully invested; in the first month, 90% of your money is still in cash earning virtually nothing. The drag on that 90% will undo much of the benefits enjoyed by the 10%.
After reading this, many people remain unconvinced. After all, with your luck, you’ll invest it all today, and the stock market will crash tomorrow.
That’s a legitimate concern — but investing slowly over time is not the correct answer. Instead, the solution is to invest right now — into a diversified portfolio, not entirely into stocks.
In other words, there are two ways to diversify: by time (investing slowly) and by asset class (diversified). Lump sums are best invested now in a diversified manner, not into a single asset class over time.
This is why dollar cost averaging is intended for the investment of money as you get it. And investing right now in a diversified manner is ideal for lump sums.
I cover all this more fully in my book The Truth About Money.