Some investors favor a dollar-cost averaging (DCA) approach to deploying their investment capital. Unlike lump-sum investing, in which the full amount of available funds are invested up front, DCA spreads out investment contributions using installments over time.
The appeal of DCA is the perception that it helps investors “diversify” the cost of entry into the market, buying shares at prices that fall somewhere between the highs and lows of a fluctuating market. So what are the implications of DCA for investors aiming to generate long-term wealth?
Let’s take the hypothetical example of an investor with $120,000 in cash earmarked for investment in stocks. Instead of buying $120,000 of equity funds today, an investor going the DCA route buys $10,000 worth of stock funds each month for the next 12 months. If the market increases in value each month during this period, the DCA investor will pay a higher price on average than if investing all up front. If the market decreases steadily over the next 12 months, the opposite will be true.
While investors may focus on prices paid for these installments, it’s important to remember that, unlike with the lump-sum approach, a meaningful portion of the investor’s capital remains in cash rather than gaining exposure to the stock market. During the process of capital deployment in this hypothetical example, half of the investable assets on average are forfeiting the higher expected returns of the stock market if they are simply in fixed income or cash. For investors with wealth accumulation goals, this could be potentially a big opportunity cost.
Despite the drawbacks of dollar-cost averaging, some may be hesitant to plunk down all their investable cash at once. If markets have recently hit all-time highs, investors may wonder whether they have already missed the best returns and so ought to wait for a pullback before getting into the market. Conversely, if stocks have just fallen and news reports suggest more declines could be on the way, some investors might take that as a signal waiting to buy is the wiser course. Driving similar reactions to these very different scenarios is one fear: what if I make an investment today and the price goes down tomorrow?
Exhibit 1. Highs and Lows
Average annualized compound returns after market highs and declines, 1926–2019
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful. This is an advertising document.
Both theory and data suggest that lump-sum investing is the more efficient approach to building wealth over time. But dollar-cost averaging may be a reasonable strategy for those investors who might otherwise decide to stay out of the market altogether due to fears of regret if the equity market have a large downturn after investing a substantial lump sum.
The stock market historically has offered a high average return, and it can be an important ally in helping you reach your goals. Getting capital deployed into equities, whether gradually or all at once, puts you in a position to reap the potential benefits. A trusted wealth planning professional can help you decide which approach—lump-sum investing or dollar-cost averaging — is better for your situation.
What’s clear is that capital markets have rewarded investors over time. Whichever method you pursue, the goal is the same: developing a sensible plan, following that plan, and sticking with it over time.