Does dollar cost averaging really work? If I have money available now, why shouldn't I invest it all at once? If the market's going up, wouldn't that be better?
Dollar cost averaging moderates risk. But you pay for this by giving up the chance for higher gains. If you took a hundred people and randomly had them fully buy into the market over a decade period, some of those people will do very well (relative to the rest) while others will do very poorly (relatively). If you dollar cost average, your performance would fall into the middle so you don't fall into the bottom (but you won't fall into the top either).
If you define dollar cost cost averaging as investing a specific dollar amount over a certain fixed time frame then it does not work statistically better than any other strategy for getting that money in the market. (IE Aunt Ruth wants to invest $60,000 in the stock market and does it $5000 a month for a year.)
It will work better on some markets and worse on others, but on average it won't be any better.
Dollar cost averaging of this form is effectively a bet that gains will occur at the end of the time period rather than the beginning, sometimes this bet will pay off, other times it won't.
A regular investment contribution of what you can afford over an indefinite time period (IE 401k contribution) is NOT Dollar Cost Averaging but it is an effective investment strategy.
Dollar cost averaging works if the stuff you're buying goes up within your time horizon. It won't protect you from losing money if it doesn't.
Also consider that the person (or company, or industry) that suggests dollar-cost averaging might want you to start up a regular investment program and put it on auto-pilot, which subsequently increases the chance that you won't give due attention to the fact that you're sending them money every paycheck to buy an investment that make them money regardless of whether you make money or not.
Vanguard said: Dollar-cost averaging just means taking risk later
We conclude that if an investor expects such trends to continue, is satisfed with his or her target asset allocation, and is comfortable with the risk/return characteristics of each strategy, the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible. But if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use. Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stocks and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.
I agree with them. Here are my additional opinions:
- The uninvested money will lose its value by inflation while it's waiting to be invested.
- As time goes by, accumulated investments diminish DCA effect.
- We can diversify our portfolio to reduce risk instead.
If you have a lump sum, you could put it into a low risk investment (which should also have low fluctuations) right away to avoid the risk of buying at a down point. Then move it into a higher risk investment over a period of time. That way you'll buy more units when the price is lower than when it's higher.
Usually I hear dollar cost averaging applied to the practice of purchasing a fixed dollar amount of an investment every week or month right out of your salary. The effect is pretty minimal though, except on the highest growth portfolios, and is generally just used as a sales tool by investment councilors (in my opinion).
Here is a deliberately simple example of Dollar Cost averaging:
Day 1: Buy 100 shares at $10. Total value = $1,000. Average cost per share = $10.00/share (easy).
Day 2: Buy 100 more shares at $9. Total value = $1,900. Average cost per share = $9.50/share (1,900/200).
Notice how your average cost per share went from $10.00 to $9.50. Now instead of hoping the stock rises above $10.00 a share to make a profit, you only need it to go to $9.50 a share (assuming no commissions or transaction fees). It's easy to see how this could work to your advantage. The only catch is that you need buy more of a stock that is dropping (people might think you're crazy). This could easily backfire if the stock continues to drop.
Over the long run, markets have always gone up. There have been down periods but they have always rebounded. If you pick any random point in the past 100 years and lump sum invested, on average you would have done better than dollar cost averaging if you kept your holdings long enough. This is why most professionals recommend lump sum investing than dollar cost averaging.
Of course, however, this discards any information about the current market conditions. If you change the statement above and lump sum invest at new highs, vs dollar cost averaging, this will skew the result to in favour of dollar cost averaging, likewise at 20 year lows this will skew the result to favour lump sum investing.