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Risks of Dollar Cost Averaging

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This is more like a mini-Devil’s Advocate post because of the nature of the idea of dollar cost averaging. Dollar cost averaging isn’t a strategy that is meant to guarantee with any sort of high probability that you’ll generate profits from the stock market, it’s meant as a risk mitigation strategy to help weather the volatility of the stock market. That being said, some people believe that by using dollar cost averaging you can get better returns, which is incorrect and that’s the idea I’ll be tackling today.

The idea behind dollar cost averaging is that you buy smaller lots of a stock until you build up the amount that you truly want, getting a nice average purchase price that isn’t at either the peak or the valley of your period. The stock market is volatile on a daily basis but increasing in the long run so by spreading out your buys you are smoothing out the curve. Proponents advise this because you won’t run the risk of buying your whole lot at a peak thus lowering your total risk involved. This is by no means a guarantee that you’ll generate profits, just that you didn’t pay the maximum price for the share in the period you were acquiring. Now the problem comes when people believe that this means DCA is a strategy for higher returns… it’s not and here’s why.

No Peaks But No Valleys Either

Just as how you didn’t buy your shares at the peak in its price, you also didn’t buy it at its lows either. If you bought one round lot (100 shares) at 10AM, one at 1PM, and one at 3PM, you probably paid three different prices for those three hundred shares and that, of course, guarantees that your average price paid is neither the peak or the valley of the stock during that period of time. If the stock was moving upwards, you paid the least in the morning and the most in the afternoon – which was more than if you bought all three hundred shares at 10AM in the first place. Now, if the stock was falling, you saved yourself the heartache as well but there is no guarantee either way.

Multiples Buys Means Multiple Commissions

Hmmm… who is recommending that you use dollar cost averaging? Could it be the folks who stand to benefit from more trades? If you make three buy orders, you generate three times the fees and commissions than if you made only one buy order! No wonder they recommend dollar cost averaging, it means more money in their pockets.

Lots of Effort

I don’t know of many brokerages, short of something like Sharebuilder where you’re paying a premium otherwise, where you can schedule purchases by time rather than by price (limit orders) and so in order to do dollar cost averaging, you’re going to have to execute those trades pretty much manually, which quit a bit of effort (at least more than making one buy).

So remember, dollar cost averaging isn’t a trading methodology that can guarantee that you earn money, it’s only a way of smoothing out your risk. Once you remember that, dollar cost averaging isn’t all that bad if you’re willing to do the legwork.

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10 Responses to “Risks of Dollar Cost Averaging”

  1. jf says:

    I agree with your post, but it should be noted that the inherent DCA that comes with contributing to a 401K with each paycheck is pretty sweet. You automatically invest the money as you earn it and you get the benefits of DCA without sitting on a large sum of money.

  2. Jeremy says:

    Well if you are talking about DCA as a lot of work it depends on what investment vehicle it is. Almost all brokerages and fund companies will allow you to establish a systematic purchase for funds at a set dollar amount at the frequency you want for no additional cost. So in this instance it is actually very easy and requires almost no work at all.

    If you are DCA with individual stocks, then you have a point. It could mean more commissions and the need to place orders yourself.

  3. Sun says:

    I don’t think DCA is ever meant for purchasing stocks when you have to pay a commission (with most brokerage) for each trade, but rather for investing in mutual funds.

  4. I don’t DCA because of any particular strategy. I DCA because I only have a set amount to invest each period. Obviously, through the workplace, it is an every two weeks event, but I also add to my Sharebuilder account monthly, in a relatively small amount. I know that I could do better on costs to save up a few months of investments and make one purchase, but the downside is that the market is (theoretically) ever-increasing, and I would rather be fully invested, if given the choice. Also, Sharebuilder does allow you to purchase stocks in partial shares – which many brokerages will not do. I did just open a Zecco account, which has substantially lower fees than Sharebuilder, and if their trading platform is OK, I will switch my SB account to Zecco. The downside to Zecco is the inability to purchase partial shares – and therefore set up automatic investing.

  5. briang467 says:

    Good post, but the second paragraph doesn’t quite go deep enough. Yes, you mitigate risk, but you also achieve a lower average cost of purchase by buying based on a dollar amount rather than by buying a set number of shares per unit of time. Just like math class, I leave the proof to the reader.

    In my case, I can do it automatically in an account with Vanguard, transferring a set amount of $ from prime money market fund to a fund of my choice, and do this every month, replenishing the MM fund as needed. Very easy, I can set it up and ignore, and Vanguard doesn’t charge as long as I pick funds within their fundaccess family – about 2600 choices (although I usually stick wth vanguard index funds, since I’m lazy).

  6. MossySF says:

    Your investments into a 401K is technically not DCA. It’s invest immediately as soon as you get the money. The DCA term only applies to a big lumpsum and you want to choose between investing immediately or spreading it out over a time period.

  7. Star Money Articles for the Week of March 5

    Here are interesting posts and news this week from the MoneyBlogNetwork members and beyond: Five Cent Nickel starts to deal with a fender bender. Blueprint for Financial Prosperity lists the risks of dollar cost averaging. Consumerism Commentary asks h…

  8. Miller says:

    Like everyone else said… DCA is more for mutual funds thans stocks so negate the transaction fees point.

    Beyond that, you’re exactly right, DCA only lower risk. It does not increase return. BrianG has an interesting point about the average share cost being lower, but I think this is playing games because this is only a consequence of getting less shares per fixed investment dollar amount (e.g., $200 a month) when they are more expensive. Brian’s statement is true, but I’d argue irrelevant because what we care about is strictly the return on our money. Its confusing though, so I might be wrong.

    Anyway, from what I’ve read, *on average* DCA will actually get you LESS return. This assumes you have the situation where you have say, $1k. Do you invest it all at once, or $250 once a month for 4 months. You’re DCA return will be lower statistically (again, run 1000s of trials) simply because your total money isn’t in the market for as long. Given, this situation is quite academic because we get our pay checks in chunks, not all at once up front. Interesting none the less though.

  9. Weekly Roundup – 03/09/07

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    Flexo spent a record amount on electricity last month.
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  10. Bernard says:

    I remembered many years back when my friend recommended me to invest into a stock and when the value went south, he suggested that I apply the dollar cost averaging method and invest even more money. However, he wasn’t making sense and he has no backing that the stock would not go even lower. He was just suggesting because he heard this method and not because he understood the market condition.
    It is really dangerous just to understand the theory without giving thoughts into it.


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