There are many different strategies and techniques people consider using when investing capital into the stock market. Dollar-cost averaging (DCA) is an old school strategy that many conservative investors gravitate towards. At its most basic level DCA is an investing practice where an investor buys a fixed dollar amount of a particular investment on a regular schedule regardless of the share price. Its more conservative aspects come from the fact that the method effectively lessens the investor’s risk of investing a large amount of money for a single investment at the wrong time.
Over the scheduled allocations, the investor will be purchasing more shares when the prices are low and less shares when the prices are high. Overall, dollar-cost averaging usually spreads investment risks over a fixed time frame and lowers the average share cost if the price goes down.
Many investors have discussed the pros and cons of this type of investing strategy, debating if the security that it brings from reducing the risk potential is worth the loss of potential gains if the particular investment does well. Vanguard, which did a research study on dollar cost averaging in July 2012, found that by using the dollar cost averaging method, an investor was essentially just taking the risk later and that the longer a person took to invest, the lower their total returns were. Though the benefits of this method are clear in terms of reducing risk, there is a psychological appeal to it as well. It provides investors with peace of mind and knowledge that if the market dips it will be saving you money.
When Dollar Cost Averaging Helps
Here are two comparative examples where using the more conservative dollar cost average is advantageous as the stock falls over a five-week period demonstrating that in this case, being more cautions is more advantageous. Let’s assume an investor has $10,000 of capital to invest in shares of ABC, which is currently trading at $100 per share. The investor could apply the lump-sum method or divide the allocation process over five weeks.
Example 1: Lump Sum
$10,000 to buy ABC stock ($100 per share)
|
Week |
New Investment |
Stock Price |
Total Performance/ |
Shares |
Investment |
| Week 1 |
$10,000 |
$100 |
100.0% |
100 |
$10,000 |
| Week 2 |
0 |
$80 |
-20%/-20% |
0 |
$8,000 |
| Week 3 |
0 |
$70 |
-30%/-12.5% |
0 |
$7,000 |
| Week 4 |
0 |
$80 |
-20%/+14.3% |
0 |
$8,000 |
| Week 5 |
0 |
$90 |
-10%/+12.5% |
0 |
$9,000 |
| Total |
100 |
$9,000 |
Obviously, the investor’s investment moves lockstep with the price action of ABC’s stock price. In this case, the overall return is down 10 percent.
Example 2: Dollar-Cost Averaging
$10,000 ($100/week) to buy ABC stock ($100 per share)
In this example, the investor allocates $2,000 per week to accumulate shares of ABC stock, regardless of price.
| Week |
New Investment |
Stock Price |
Total Performance/ |
Shares |
Investment Value |
| Week 1 | $2,000 | $100 |
100.0% |
2 |
$2,000 |
| Week 2 | $2,000 | $80 |
-20%/-20% |
25 |
$3,600 |
| Week 3 | $2,000 | $70 |
-30%/-12.5% |
25.57 |
$5,150 |
| Week 4 | $2,000 | $80 |
-20%/+14.3% |
35 |
$7,886 |
| Week 5 | $2,000 | $90 |
-10%/+12.5% |
22.22 |
$10,871 |
| Total |
102.79 |
$10,871 |
In this instance, the investor actually makes a profit of 8.71 percent despite the overall performance of ABC being down 10 percent during that period.
When Dollar Cost Averaging Hurts
Here is a comparative example that demonstrates the downside to the less risk approach as the stock rises over a five-week period demonstrating that the lump sum strategy generated more capital.
Example 1: Lump Sum
$1,000 to buy ABC stock ($100 per share)
| Week |
New Investment |
Stock Price |
Total Performance/ |
Shares |
Investment Value |
| Week 1 |
$10,000 |
$100 |
100.0% |
100 |
$10,000 |
| Week 2 |
0 |
$120 |
+20.0%/+20% |
0 |
$12,000 |
| Week 3 |
0 |
$130 |
+30%/+8.3% |
0 |
$13,000 |
| Week 4 |
0 |
$120 |
20%/-7.7 |
0 |
$12,000 |
| Week 5 |
0 |
$140 |
+40%/+16.6% |
0 |
$14,000 |
| Total |
100 |
$14,000 |
Example 2: DCA
$1,000 ($100/week) to buy ABC stock ($100 per share)
| Week |
New Investment |
Stock Price |
Total Performance/ |
Shares |
Balance |
| Week 1 |
$2,000 |
$100 |
100.0% |
2 |
$2,000 |
| Week 2 |
$2,000 |
$120 |
+20.0%/+20% |
16.67 |
$4,400 |
| Week 3 |
$2,000 |
$130 |
+30%/+8.3% |
15.38 |
$6,767 |
| Week 4 |
$2,000 |
$120 |
20%/-7.7% |
16.67 |
$8,246 |
| Week 5 |
$2,000 |
$140 |
+40%/+16.6% |
14.29 |
$11,621 |
| Total |
65.01 |
$11,621 |
As the examples show, the elongated process actually hurt the investor’s overall performance as it kept cash on the sidelines while shares of ABC continued to rise.
So while no one can predict with 100-percent certainty how any investment will perform, being aware of different investment strategies and the various methods in which capital can be deployed can help investors limit their risk or increase their exposure, depending on preference.
