Dollar-cost averaging (DCA) is the practice of making regular, equal-value purchases of an investment instrument (usually equities), rather than making a single lump-sum investment as soon as possible. The perceived benefit of DCA is that it enables the investor to buy shares at variable prices throughout the investment period, purchasing more shares when prices are lower, and fewer shares when prices are higher. It’s smart to buy low, right?
The problem with dollar-cost averaging is that it’s another way of trying to time the market — albeit, methodically.
For example, let’s say that you’ve earmarked some money in a savings account and start dollar-cost averaging this money into a broad stock market fund. By doing so, you would be continuously betting that the average share price for the remainder of the DCA investment period will be lower than the current share price if you were to make an immediate lump sum investment. In other words, you’re keeping your money out of the stock market in anticipation that the market will go down.
On a yearly basis, the stock market (namely the S&P 500 index) posts positive calendar year returns about 75% of the time, and negative returns about 25% of the time. So if you happen to dollar-cost average during such a down year, you will indeed come out ahead, as you will have capped your downside. But remember that by employing DCA as an investment strategy, in any given twelve month period, dollar-cost averaging will be a suboptimal strategy about two to three times more often than not.
Every dollar that you leave out of the stock market during a DCA investment period is a dollar guaranteed to earn low returns — languishing in a savings account, U.S. Treasury fund, etc.
This interactive lump-sum vs. DCA calculator demonstrates that lump-sum investing wins over dollar-cost averaging about twice as often.