Investment Dollar Cost Averaging Tips

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Investment Dollar Cost Averaging (AKA DCA) has been touted for decades by many as a way to put money into "the market" without taking the risk of buying too much too close to the top.

You basically put a little cash into the market periodically at a set point in time regardless of what the market is doing. Over time, in theory, you would have avoided putting all of your money in when the market was high. If you put too much in when the market is high, and then you need to sell when it's low, then you'll lose money.

Dollar Cost Averaging is a market timing technique. In this case, it's used to avoid making a market timing decision.

Actually, it's mostly a sales technique designed to make sales today. It overcomes the objection, "I don't want to put all of my money in the market now because I think it's too high and is going to go down."

Then a plan is put into place where money is automatically invested at certain intervals, and the salesperson gets paid every time this happens.

If you use asset allocation correctly, then you won't need to use investment Dollar Cost Averaging. Why? Because with asset allocation, you're investing in many "markets." The investing tools on this site use many markets: Short-term U.S. bond, Intermediate-term/Long-term U.S. bond, Short-term muni bond, Intermediate-term/Long-term muni bond, High-yield (junk) bond, Int'l bond, Large-cap value, Large-cap growth, All/Mid-cap growth, Small-cap growth, Micro-cap, Technology, Biotech, Health care, Venture, Internet, Int'l all-cap, Int'l small-cap, Emerging Markets, and Real estate.

Some are up and some are down at the same time. The reason Investment Dollar Cost Averaging is so popular, is because it's a popular sales technique (so you'll read about it everywhere), most people don't understand asset allocation, and so when they think of "the market," they're only thinking about the U.S. stock market (S&P 500 type stocks).

When you think in-terms of many markets (asset allocation), then investing in Dollar Cost Averaging becomes totally irrelevant.

For example, say you received a huge cash windfall and you need to invest it. You just implement an asset allocation and it calls for exposure to 15% in U.S. Large-Cap Growth. Don't try to guess if that market is too high right now; just invest the whole 15% now. The worst thing that can happen is that you invested when Large-Cap Growth was high, and you will either have a loss, or it will take years to make a decent profit.

The point is that you put the other 85% into different markets that go up and down at different times than U.S. Large-Cap Growth. Even U.S. Large-Cap Value stocks don't peak at the same time Large-Cap Growth does. Value and growth will always take turns, and over time the returns are almost identical (since data were recorded back in 1921, Large-Cap Growth has outperformed Large-Cap Value by only about 0.12% annually).

If you invest your money all at once, then you're going to buy some markets when they're up, some when they're flat, and some when they're down. You're also doing the exact same thing when you buy using Dollar Cost Averaging. Nobody knows what the exact current state of any market is, or what will happen to it in the future. So why trouble yourself with all of this? Just do it all now and get it over with! If you don't, then you're going to be sitting around in a state of confusion fear for the rest of your life. You're not going to make any money like that!

Plus the "safe" interest you'd be making with the bonds will make up for some losses from buying at the top. Next, everyone is usually wrong when trying to predict a market top. Also, if the market is going up, then you're going to be losing a lot of profit by sitting on the sidelines waiting when you could have been invested.

Asset allocation can be looked at as an enormous board game with about 25 buckets that hold money (each of the 25 buckets could contain several sub-buckets too). There are trillions of dollars in all of the financial markets, and all of this money is spread between these buckets (about ten to twelve trillion just in U.S. stocks alone at the time of this writing). The buckets all stay on the board at all times, and over one trillion dollars gets shuffled between buckets on a normal day. For example, if tech stocks go down 10% in a day, it's because more people sold, and wanted to sell, tech stocks than wanted to buy them that day. These sellers got money when they sold, and if they didn't buy any other kinds of investments, this money just went into the cash (money market) bucket. Over the next day or so, this money finds its way into the other buckets. Which buckets they go into are mostly determined by the security selection and market timing decisions of short-term traders.

One of the main points of asset allocation is to have a little bit of just about every major bucket that this cash is likely to go into. This way no matter where the money goes, you're already there. This eliminates the need for market timing, because you're in most every major market all the time already. For example, if ten billion worth of technology stocks were sold net in a day, then this ten billion dollars has to go somewhere - cash, bonds, real estate, large-cap value stocks, etc. If you consistently own a little bit of everything, then it's hard to lose a lot of money long-term because it all has to stay on the table in one bucket or another. It's just a question of which bucket it will be shuffled to next, and when. Nobody knows, so why try to guess?

It's rare for all (major) asset classes (buckets) to be down at the same time for very long. So when a well-allocated portfolio is down, it doesn't stay down for very long. This is because if a lot of markets are down at the same time, that means everyone is hiding in cash/money markets. People don't like getting 1% - 3%, so they're just waiting to pounce and put this money to work somewhere. When it happens, there is usually a big sudden rally in at least one major asset class.

By playing the game this way, instead of guessing which bucket will do best short-term, you not only eliminate the risk of not being in the right bucket at the right time, but you also don't have to guess where the right bucket will be in the future. If you try to predict where money will move next, more than likely the bucket you took the money from will be the next place it will go, and money is just waiting to leave the bucket you picked. If you paid capital gains taxes on the sale, you would lose on four fronts (taxes, trading costs, and being wrong with your market timing bet twice).

Since nobody knows when, and by how much, money will move to next bucket, we feel it's just best not to guess. We feel just having a balanced mix between most all of the buckets, all of the time, is the best way to minimize investment risk, and still get good returns. Be in as many viable asset classes as you can all the time and you can always tell people you were there for the big rally at dinner parties, while the stock pickers and the market timers missed the boat! You'll always be able to say you were there if you're always everywhere.

So don't use Investing Dollar Cost Averaging, asset allocation works much better, all the time, no contest.

Salespeople needing to make the sale: Use asset allocation instead of DCA. This way, you'll get all of the money now; instead of hoping people will continue to use the DCA program.

More about why asset allocation is better than Dollar Cost Averaging

An ancient letter sent to a client about the benefits of DCA:

Dear William and Miriam:

By now you have received confirmation statements from the funds showing that we had done exchanges for both IRA accounts at Fidelity Advisors.

Here’s an explanation of why we recommend investing on a monthly basis:

Generally speaking, there are 3 ways to invest new funds into the equity portion of your portfolio:

#1) You can invest the entire proceeds at once (lump sum investing),

#2) You can try to time the market and invest periodically, or lump sum, when you feel the markets are undervalued,

#3) You can use a risk reducing technique called Dollar Cost Averaging.

The problem with #1 is that the markets could decline significantly soon after you invest, and then remain flat (or go down further) for long periods of time. If this happens, it might take a long time to get back to where you should have been.

The problem with #2 is that nobody can reliably time any market. To solve the risks in the first two methods, we recommend the third method.

Dollar Cost Averaging (Investment Dollar Cost Averaging) is just periodically investing the same amount of money on regular intervals. It is a systematic method of investing new funds into equity investments that removes emotions, market timing, guesswork, and the risks of lump sum investing. The usual method is to have funds automatically come out of cash equivalent accounts (e.g., checking or money market funds) on a monthly basis. These funds are used to purchase financial assets that have both substantial short-term price fluctuations and a history of increasing over the long-term (e.g., equity mutual funds). Most mutual fund families have automatic mechanisms to facilitate Investment Dollar Cost Averaging.

The risk reducing advantages of Investment Dollar Cost Averaging stems from three major assumptions:

1) Equity prices generally increase over the long-term,

2) Equity prices fluctuate substantially around this upward trend over the short-term, and

3) Nobody can time the markets.

History has proven these assumptions to be valid. Lump sum investing would be the best strategy only if the first assumption held, and you could time the markets short-term. The possibility to profit is higher with lump sum compared to Investment Dollar Cost Averaging, but the risks are much higher too.

By investing the same amount of money every month, you buy more shares when these short-term fluctuations in price are in the negative direction, and vice versa. If you don’t need the money until the end of the long-term, then the lower your purchase prices are along the way, the better (buy low, sell high). Given that these 3 assumptions hold, the average price you paid for your purchases will be lower than the price at the end of the period (as long as you don’t sell when the market is down. No strategy will help when you buy high and sell low!).

Here’s an example of the difference between lump sum investing and dollar cost averaging over an adverse time period (a down year). We used market values that resemble DJIA points to make it more familiar (multiply share values by 100). The lump sum investor would show an annual loss for the year in this scenario, and the Investment Dollar Cost Averaging investor would show a gain.

In summary, Investment Dollar Cost Averaging is just a technique to lower the risks in equity investing by spreading your purchases over a longer time frame than lump sum investing. Over the long-term, this averaging process reduced the risks of buying high with a large proportion of your money.

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