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Risks of Dollar Cost Averaging

Posted By Jim On 03/07/2007 @ 8:30 am In Investing,Personal Finance | 10 Comments

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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