Is Dollar-Cost Averaging Worth It? Pros and Cons of The Famous Investment Strategy

Investors are often looking for ways to maximize the wealth-building process. On paper, investing may look simple: buy low and sell high, but markets don’t operate in one dimension. 

Markets can be volatile, and that volatility means investors may benefit from a strategy for building and sustaining long-term returns. One approach to accomplish this goal is dollar-cost averaging (DCA). 

What is dollar-cost averaging, and does it live up to the hype?

What Is Dollar-Cost Averaging? (Plus an Example In The Wild)

Dollar-cost averaging is an investment strategy that calls for fixed investments of equal portions at regular intervals regardless of market activity. Perhaps the simplest example of this strategy is payroll deferrals for your 401(k). 

Say you elect 15% of your paycheck to your 401k. You invest that 15% whether the market is high or low, whether the stock prices are up or down. Regular investments bring consistency month to month.

Many investors also use this method for regular contributions to an IRA or brokerage account—investing $500 a month in an IRA to max out a $6,000 annual contribution limit, for example. 

But dollar-cost averaging can be used for non-recurring investments as well, which is where investors have different decisions to make. 

Let’s look at an example of dollar-cost averaging to better understand what it would look like in real life. 

Ben has $3,000 to invest and has decided on an investment vehicle. He decides to invest $500 a month for six months.

But it could just as easily have gone the other way. If the cost of the shares steadily increased over six months instead of fluctuating, Ben would end up with fewer shares than if he had invested the lump sum upfront. If Ben invested a total of $3,000 at $15 a share, he would own 200 shares. With the dollar cost averaging method, he would own 218.16 shares at an average price of $14.16 per share. In this case, dollar-cost averaging worked well for Ben!

4 Compelling Reasons for Dollar Cost Averaging 

Dollar-cost averaging can bring a fixed consistency to your portfolio. It’s a strategy that can mitigate some of the market’s volatility and accommodate several types of risk tolerance. 

1. Helps Investors Avoid Market Timing

Timing the market can be a slippery slope, like tackling a black diamond run the first time you put on skis. There’s a possibility you could come out unscathed, but you may also sustain some injuries (whether physical or psychological). Dollar-cost averaging allows investors to make regular contributions without undue concern about pricing fluctuations.  

2. Limits Emotion-Driven Investment Decisions

It’s important (yet challenging) to avoid the “if only” feeling regarding the market. There will always be opportunities, some you may miss, and some you may capitalize on. DCA helps regulate those emotional decisions. 

It can also help ward against impulsive decisions to buy up all of a stock at a low price, get out of the market when investments fall, or sell off more than you planned at market highs. 

Money will always have an emotional component. But investment decisions should be made with data, research, and educated insights. 

3. Ensures Consistent, Long-Term Investing

To find success in nearly any endeavor—career, sports, relationships, health, etc.—it’s important to have consistency. Long-term investing is built on consistency. Take retirement as an example. You invest about 40 years for retirement. That takes a lot of discipline and consistency to reach your ideal retirement number. 

Additionally, your investments have time to compound. Investing $1,000 every month for a year is different than one lump sum of $12,000. Every month, the $1,000 has the opportunity to compound and rise in value. 

4. Risk Management Strategy

Since you’re not trying to time the market, dollar-cost averaging is a practical risk management tool. You offset risk by purchasing shares at fluctuating prices instead of risking the first share price you see. 

Dollar-Cost Averaging Has Limits, Let’s Look

No investment strategy works all the time, and no one investment strategy makes sense to blanket your entire portfolio. It’s prudent to understand each strategy’s merits and limitations to make an informed decision on what’s best for you. 

One positive element of dollar-cost averaging is that investors can bring more automation to their strategy, but sometimes it benefits people to take a more active role. 

Think about it like cruise control in a car. The cruise is perfect for a wide-open road, a full tank of gas, and several miles left in your trip. It’s not so hot in congested traffic and varying terrain. 

The same idea is true for investing. Oftentimes, long-term investing benefits from a uniform, steady approach, but long-term investing isn’t like an empty open road; there are bumps, curves, and different opportunities along the way. 

1. You Could End Up With Fewer, More Expensive Shares

One risk of dollar-cost averaging is the possibility of buying fewer shares at a higher price. Let’s bring Ben back. If the dollar cost average over six months ended up being $16, he would have 187.5 shares instead of 200 if he did a lump sum at $15 a share. 

A 2012 Vanguard study found that, given historical data, investing in a lump-sum is more lucrative than dollar-cost averaging 66% of the time. The study also found that the longer the investment time frame, the greater chance that a lump-sum method produced higher returns.

The study considered different asset allocations, markets (US, UK, and Australia), and time-frames. So if you find yourself with a large chunk of change, investing all of it outright could be the more beneficial move.

Lump-sum investing, however, was found to be less advantageous in down markets than dollar-cost averaging, which points to the strategy’s inherent risk management component. And in the end, lump-sum investing beat out dollar-cost averaging by 2.3% over a ten-year period—a relatively modest win. 

2. Beware of Trading and Transaction Fees

Dollar-cost averaging becomes a lot more expensive depending on the fee structure from your financial custodian. You may have to pay separate transaction fees. Imagine having to pay that fee one time as opposed to six. 

3. Your Lump Sum Could Be Stuck Waiting With Low-Interest Rates

So you can invest $5,000, but you want to spread the investment over several months. Where are you going to store the remainder? It may be in cash or equivalents, making significantly lower returns. A lump sum opens up the full amount to compounding effects and the potential for more significant growth over time.

4. It’s Not A Replacement for All Risk Management

Dollar-cost averaging isn’t a magic fix for risk. There will always be volatility and market swings; just because you ease your money into it doesn’t make it immune. You still have to do the work to make good/sound investments. 

The Key To Smart Investment Decisions? Create A Tailored and Flexible Strategy 

You want to build an investment strategy that carries you to and through retirement. Is dollar-cost averaging the answer? 

Sometimes. 

It can be a great strategy to include, but there are times where it falls short, and you should consider other methods. The most important thing is that you create a plan aligned with your risk preferences and time horizon, as well as your goals and vision for the future.

Ready to take your investments to the next level? Our team at Legacy Wealth is here to help you create a long-term investment strategy that moves you toward your goals. Schedule a 15-minute call with us today.

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