Is Dollar Cost Averaging (DCA) a good idea?
One of the time-honored investment methods, dollar cost averaging investment strategy (DCA) is a sustainable way to stay invested in the market for a long period of time. As Burton Malkiel, the renowned economist and author of “A Random Walk Down Wall Street” put it:
Invest, but not all at once. Ease it into the market over time in equal installments at regular intervals.
-Burton Malkiel, A Random Walk Down Wall Street
It is as simple as it sounds. Dollar cost averaging is the technique of putting in an equal amount of money at regular intervals into the market, no matter what the market condition is. We don’t try to time the entry into the market, nor do we time the exit from the market. This is a long term strategy to stay invested in the market and enjoy the returns.
Advantages of Dollar Cost Averaging
What you should know about dollar cost averaging technique
Removes emotional component
One advantage of DCA is that by investing mechanically, emotion of the investor is taken out from the component of decision making. In investing, emotions often do more harm than good.
Many investors tend to bail out and sell their shares at a loss during a wild swing down of the market. As a DCA investor, you are probably more happy when the market swings down temporarily because it means that you can buy more shares with your regular contribution into the market.
Avoids bad market timing
No one can time the market perfectly. If you invest all of your money in a lump sum into the market, there is a risk that you may invest right before a major market downturn.
With such a huge commitment into the market, many investors panic during a downturn, especially a major one such as the stock market crash from 2008-2009.
With DCA, there is no such thing as good or bad market timing. Our aim is to stay invested for long term and live off the dividends and appreciation, so our only job is to find the best vehicles to invest in and start investing early with DCA.
Practical for small-time investors
If you don’t have a lump sum of money sitting around ready to be poured into the equity market, this is your best bet at getting rich slowly.
Most of us receive regular salaries and don’t have a large amount of disposable income, making DCA is the most practical way to start investing into the market.
Since there is no good or bad timing with the DCA strategy (as long as you are planning to stay invested for a long term), most of us can start getting invested almost immediately as long as we have an intact emergency fund as backup.
Disadvantages of DCA
Given the many advantages and practicality of dollar cost averaging, there are a couple of potential disadvantages when it comes to DCA strategy that you need to consider as well.
Market tends to go up over the long term
Given the tendency of equity market to go up over a long period of time, it is better to invest a lump sum as early as you can compared to buying the shares over a long period of time.
DCA technique can potentially reduce your returns compared to lump sum investing in a rising market because the fixed periodic contribution buys you lesser share when the price rises.
However, the flip side of the story is true as well.
Although DCA reduces return in a rising market compared to investing a lump sum, it can blunt losses in a falling market given the same principle, by buying more shares with the same amount of periodic contribution during a market downturn.
Not responding to changing market environment
Although DCA takes the guesswork and emotions out of the equation, it is ultimately a passive investment strategy that does not respond to changing market conditions, such as new information about a particular stock or sector that might make you rethink your investment approach.
To counter this disadvantage, we recommend that you employ DCA on low cost and broad-coverage index funds, which provide enough diversification across different sectors and countries, as well as investment vehicles (stocks and bonds).
Such portfolio ensures that you are fully diversified and minimize single stock/sector/country risks. Read our top picks on index funds that can help you achieve total diversification at a low cost.
The Bottom Line
To put it simply, DCA is an affordable and sustainable way to stay invested in the market without taking big risks and preventing the regret of diving into the market right before a sharp correction.
It takes impulsiveness and guesswork out of investing, which is generally a good thing when it comes to investments. As long as you have enough emergency fund in your savings account, putting your disposable income into the market is a more rewarding way to save your money compared to saving it in the bank.
smart_investor
What if I can’t save enough to put into the indices every month?
Edward
If you can’t save enough for monthly contribution, save what you can for every month and channel them into the index funds once you have enough. Be disciplined and consistent, save the same amount for every single month and don’t try to time the market.