Question:  

What is Dollar Cost Averaging?

Answer: 

Dollar cost averaging (DCA) is a strategy to make regular investments of the same amount of money over time, no matter what financial markets may be doing. DCA is designed to avoid the tendency to try and “time” the market by buying low and selling high. DCA is designed to reduce the impact of market gyrations, mitigate emotion, and sidestep the inclination to buy and sell at “just the right time.” However, using DCA could also leave some returns on the table when markets are rallying. Though volatility is uncomfortable, missing even a handful of the market’s best days can be costly for a long-term investor. 

Missing Out Hurts

Markets tend to penalize those who attempt to time it and reward those who stay the course. Over the past 20 years, investors who missed just the 10 best days of the equity market, cut total return nearly in half to 5.6% on an annualized basis, compared to 9.8% for someone who remained invested for the duration. 

The best days often come during times of extreme volatility. Some of the biggest one-day gains happened during crisis periods during October and November 2008, March 2009, and March 2020 during the COVID-19 pandemic. The more days missed, the greater the cost. It is time in the market that matters, not timing the market. 

Historically Speaking

Reviewing 40 years of data with the S&P 500 index as a proxy, Raymond James researchers analyzed long-term returns over multiple time periods to calculate the impact of a DCA strategy. During the review period, the market experienced four peaks: August 31, 1987, July 31, 1992, August 31, 2000, and October 31, 2007. No matter what month, investing a lump sum on the first day of any month during the 40-year period yielded an average annualized 10-year return of 11.7%

The opportunity cost for holding cash and not participating in the market is high. Cash produced the lowest return of any scenario with an average annualized 10-year return of 3.1% over the study period. Someone who began investing at a market peak but used DCA realized an average annualized 10-year return of 10.4%. 

For the first time in a long time, money market rates are attractive in sharp contrast to much of the past decade. Rates can now be found in the 5% range whereas they had been around 0.5%. Creating a financial plan includes asset allocation to the three asset classes: stocks, bonds, and cash. Some investors overlook the fact that cash is an asset class. Whether and how much an investor should allocate to cash depends on the intended objectives of your capital and cash flow needs. 

If your goal is growth appreciation, it’s important to be aware that the cost of waiting could be high. It may be enticing and could compensate for the potential risks of volatility. However, lost opportunity risk is real and proven to be material should markets rally during the same period. Fear of missing out (FOMO) as opposed to using DCA can cause investors to chase markets at the wrong time. 

You may have heard of the traditional 60/40 portfolio for balanced investment objectives. This would prescribe owning roughly 60% stocks and 40% bonds. Typically, stocks and bonds function as counterbalancing hedges for one another. In 2022, after decades of low inflation, we were hit with high inflation, rising interest rates, and weakened growth, resulting in stock and bond prices moving down at the same time. A stock correction in combination with the bond market’s worst performance since 1975, made it a challenging year for investors. 

From 1927 to 2023 (96 years), the S&P 500 index saw positive performance in 63 years, or 66% of the time. The key to dollar cost averaging isn’t to try and time the market but rather to start investing and continue to make consistent investments over time. DCA may be a way for those uncomfortable with starting the investment process to enter markets in an unemotional way. Stay focused and plan accordingly.