The Myth Of Dollar Cost Averaging

by: Reel Ken

What, exactly is dollar cost averaging?

Does dollar cost increase returns?

Does dollar cost decrease risk?

"According to folklore, an aerodynamic engineer used LOGIC to prove a Bumblebee can't fly."

A Myth is a widely held but false belief. Myths arise and propagate because they seem to make logical sense. Many things make logical sense and are true. Myths are not true because they either 1) use faulty logic, or 2) fail to adequately test their hypothesis against all the relevant factors.

I contend that the advantages of Dollar Cost Averaging (DCA) are Mythical and am offering this article in support of that contention.

I suggest that proponents of DCA are using incomplete logical arguments... just as the fabled Bumble Bee engineer did.

I am well aware that the belief in DCA as a beneficial investing technique is so ubiquitous and ingrained that the overwhelming majority of readers, at this point in the article, will be uttering to themselves "this author is crazy, let me move on".

So, in the hope that curiosity will keep these readers engaged I offer this tidbit... Most every serious study conducted over the last 30 years has concluded that DCA is sub-optimal investing. DCA has been shown to be no more advantageous than Random Investing.

In fact, this conclusion is so universal that the majority of studies now being conducted focus on WHY so many people hold this mistaken belief.

It is my sense that DCA as an affirmative investing technique is widely held because it is simple to explain and seems to be correct. Human nature is such that people tend to challenge what seems like it doesn't make sense and accept storylines that seem right... without putting that storyline to the test.

Before we get started, we need to erase some misconceptions about DCA.

DCA has taken on a wide variety of definitions and has expanded beyond its intended meaning. DCA is a methodology to deploy an existing lump sum of cash. It is NOT the methodology whereby one simply makes systematic investments of monies as they become available. Let me explain:

If one is making monthly investments in their 401(k) or from discretionary income, they are not engaging in DCA, but, rather Systematic Investment. They are NOT deploying existing cash, but engaging in a regimen to deploy cash as it becomes available. Surely, they will be buying shares at various prices and will have an averaging of the costs, but, in these cases, averaging is a byproduct of the Systematic Investment Plan (SIP).

I certainly encourage anyone making systematic investments to continue to do so. This article is not intended to challenge the benefits of investing on a regular basis over the long run. Quite the contrary, I encourage readers to invest as much as they can for as long as they can.

However, when someone invests cash as it becomes available, they are simply accumulating investments in the only way available to them... Que Sera, Sera.

Turning to DCA, this must be distinguished from SIP. Let's say one has cash accumulated over the years, inheritance, bonus, whatever, and is considering whether or not to commit it in a lump sum or enter the market gradually. Say 1/12th each month for a year. That is DCA - a method of allocating existing assets.

This is where the "logic" of DCA comes into play. If one deploys the lump sum gradually, in equal installments on a regular basis, the "logic" is as follows:

1) One buys less shares at high prices and more shares at low prices reducing the average cost per share and therefore increases the profits.

2) The discipline of making regular deposits, even as the stock market drops, counters the emotional barriers most investors face.

3) Deploying money on a gradual basis reduces risk.

On the surface, these "logical" extensions seem hard to dispute. They are common sense. Or are they?

One can go to hundreds of websites and find thousands of charts, tables and examples that seem to prove this point. One typical (and nicely drawn chart) illustrates the general concept:

Pretty convincing, I must say.

However, what all these charts have in common is that they show a falling price, usually shortly after the program starts so that the average price ends up below the initial price.

I think we can agree if the average price ends up higher than the initial price, lump-sum investing has greater returns than DCA. Here's a chart representing that outcome.

So, let's all agree that:

1) One can "prove" any position they want to "prove" as long as they are in control of picking the share prices that illustrate the result.

2) Falling prices, soon after starting, favor DCA scenarios.

3) Rising prices favor lump-sum investing.

This begs two questions:

1) Is it more efficient to allocate cash by spreading it over time using substantially equal periodic payments, or some other method?

2) Does spreading the investment, periodically, over time reduce risk?

I wish the answer to this was as simple as showing one chart, but it isn't. I'll provide some links later on, for the enthusiast, but, for now, I'll try and hope I succeed to explain why DCA comes up short.

Since it is my contention that DCA survives as a myth because the "logic" seems plausible, I'll attempt to avoid all the math, and instead, provide the logical "holes."

Psychological factors: DCA provides a disciplined regimen, if followed, that will invest money when the market falls. This discipline is essential. We would all agree that if one didn't deploy cash when the market dropped, DCA loses one of its biggest advantages.

In this regard, DCA expects that the investor will overcome the natural behavioral tendency to make investments in a down market, simply because they made a logical decision to do so, some months in the past.

Remember, we're NOT talking about investing out of your paycheck into your 401(k) and SIP or similar AUTOMATIC plans. That's NOT DCA. DCA is where one has, say, $120,000, decides to invest $10,000 per month, the market drops suddenly by 5% and DCA demands the next $10,000 to be deployed.

Most every investor struggles emotionally with market volatility. How many times have you laid out a plan only to second-guess yourself at the moment of truth?

I'm a disciplined strategic investor and look for volatility to reap the biggest profits.

I've been at it for 45 years, written countless articles and am hedged 24/7/365 and STILL, every time the market drops, my disciplined self is at war with my inner fear. Only my training and developed skills keep me on track, and only most, not all, of the time, I, even I, succumb. I can only imagine the difficulty for the typical investor.

So, the theory that DCA provides discipline is nice, but the record doesn't support that it actually happens unless it is through some automatic arrangement, such as a 401(k), and these are not actually DCA.

Furthermore, if an investor is so disciplined that they will execute buys in a down market, they probably aren't interested in DCA but lean towards more strategic or opportunistic investing.

In fairness to DCA, there is one psychological advantage. One that is acknowledged amongst advisors but not readily relayed to investors. DCA is used by advisors and money managers as an aid to help overcome the fear that most investors have about deploying a lump sum. It assuages fear of a market drop by presenting a comforting story-line that "a market drop is your friend."

The advantage isn't one of discipline, rather that it overcomes inertia.

Increased Returns: This is a little more difficult to relay without math, but I'll do my best.

First, let me say that investing has no absolutes. Every investment scheme that was ever devised can show outsized returns under favorable conditions. So, when we look at different methodologies, we need to focus on what is the most likely outcome. One may win playing the long shot, but over time, investing success goes to those that get it right most often.

Is the most likely outcome more favorable to DCA or lump sum?

Since DCA rests on "logic," let me start with a "logic problem."

Let's assume that DCA is IN FACT SUPERIOR to a lump-sum investment.

By example, let's say one has $120,000 they want to deploy into the market. Though there are an infinite number of Random Methods one could employ, and only one would be optimal (and we can't possibly know in advance which one), we'll just look at DCA versus lump sum.

DCA: The investor deploys $10,000 per month, religiously, into stocks until the entire $120,000 is deployed. Bravo! Hurdle #1, discipline, overcome.

Stop and think for a minute... If DCA results in lower average price than lump sum, ergo more profits, then the investor has more money than they would have had, if invested in a lump sum. All the DCA promotional charts illustrate this outcome.

Wouldn't it follow that going forward, now that all the money is in the market, one should liquidate the $120,000 in investments and re-deploy it at the rate of $10,000 per month? And to do this, re-deploy religiously every year.

In essence, if DCA posts higher returns than lump sum, then Buy-N-Hold will post lower returns than consistently liquidating and re-deploying.

Let me try to drive this home. If we had two investors "A" and "B."

Both have $100,000 to invest.

"A" invests his $100,000 in a lump sum. "B" $100,000 cash into the market according to DCA over 12 months.

Well, if DCA is better that means "B" would have more money than if "B" invested as a lump sum.

Well, if "B" would have more money by utilizing DCA, then "B" will also have more money than "A" ... because "A" had invested a Lump Sum.

Therefore, "A" should have done as "B" did. Yes, "A" should liquidate their holdings and deploy the amounts over 12 months. In fact, this should be done, religiously each and every year. As absurd as it sounds, liquidation and re-deployment every year is the logical extension of a belief that DCA outperforms Lump Sum.

Taking it to the extreme, as soon as the first $10,000 of the $120,000 is deployed, wouldn't it also follow that the optimal thing to do is to immediately liquidate this $10,000 and re-deploy it over the remaining months?

After all, this $10,000 represents money currently invested. If DCA posts better returns than investing money currently, then we should always be investing money periodically in the future as opposed to holding it in investments.

Repeat: If investments do better if money is allocated in the future then it doesn't make sense to deploy money now.

In fact, if we looked at complex mathematical solutions, they would confirm this ridiculous outcome - as soon as funds were invested, they should be liquidated and re-deployed. The net result would be practically no static investment at all.

So, taking DCA to the extreme, we would conclude that the BEST investment is, in fact, NO investment.

Logic leads us to conclude that if DCA is the better allocation of funds, then NOT investing is better than investing. Do you want to believe that?

Let's look at the other side: Assume Lump Sum posts better returns than DCA. In order for this to be true, we must conclude:

1) The beginning price must be less than DCA averaged price. Ergo the stock market must rise more often than it falls.

2) It makes more sense to Buy-n-Hold than constantly liquidate and re-deploy.

Now I ask you, which scenario makes the most sense: One that suggests NO investment beats ANY investment or one that relies on the market going up more than down?

But let's not stop there; after all this is about most likely outcomes.

Most Likely Outcome: The historical record on the market is pretty consistent. The market moves up between 60% and 66% of the time. This holds whether we look at decades, years, months, days or intraday.

If this pattern continues to hold, then DCA would be buying at higher prices about twice as often as lower prices. Though the actual studies use complex math to reach this result (as they should) common sense is enough to get there. In fact, Vanguard did a study and concluded exactly this (not sure it needed a study; to me it is common sense)

This result was further confirmed by Dubil (2005) that found that the expected return from a DCA strategy is 30 percent lower than that of a lump-sum investing strategy. Wow... 30% lower.

Risk Reduction: This is my favorite subject on DCA versus Lump Sum. The DCA premise is when the market drops, one is less exposed and therefore risk is reduced.

Certainly makes logical sense; seems impossible to disagree with, or is it?

Let's examine this premise more closely. Since DCA requires (and brags about) the advantages of investing on market drops, if there was a market drop, doesn't the DCA require continued investment? In fact, doesn't DCA require continued investment until all monies are invested?

Doesn't that mean that over the time period to completion, whether one engages in lump sum or DCA all the earmarked monies are fully invested and therefore the entire $120,000 will be at risk at some time?

Doesn't it follow that market drops don't really speak to lower risk, but the possibility of greater returns by investing in down markets?

Furthermore, risk shouldn't be measured in a vacuum but compared with reward (risk/reward). There are methodologies to assess this such as Sharpe Ratio and Sortino Ratio and they conclude that risk/reward favors lump sum.

Lastly, if one suggests that risk is reduced in the down market scenario, doesn't that encourage the investor to see market drops as a risk issue and not a buying opportunity?

Summary: Dollar Cost Averaging is one of the most widely held beliefs on investing methodologies. Despite this ubiquitous belief, every meaningful study that has been done fails to confirm DCA as anything other than sub-optimal.

Certainly, one can come up with historic or hypothetical instances when DCA is superior to lump-sum investing. The question is whether those scenarios are more or less likely to prevail.

DCA's effectiveness depends upon some manifestation of a down market scenario. So, if one suspects one of these scenarios, then DCA would make sense. But if one must first determine whether the market is going to move favorably up or down, then wouldn't it be fair to consider the decision to use DCA over lump sum a Market-Timing decision.

The irony of DCA is that promoters present it as an alternative to Market Timing, when in fact, its usefulness can only be rationalized as a Market-Timing tool.

Conclusion: There are many different theories on investing strategies. Every strategy will win in some situations and lose in others. That being the case, the successful investor needs to choose amongst all these strategies the one with the greatest chance of success.

I'm not suggesting that lump sum is the best strategy. Actually, those that follow me know I don't use lump sum, but rather strategic investing.

What this article is about is to illustrate that every investor should try to search out what's best for them. In doing so, one must do independent research and not just go with "Crowd Mentality."

In this article, I hope I was able to illustrate that one of the most widely held beliefs of the "Crowd" is just a Myth.

And if something so widely held is Mythical, then one needs to understand that the only truth to be found is the truth one finds themselves.

Citations: I avoided incorporating lots of references in the article for a specific reason. I wanted to illustrate that one doesn't need high math skills or research capabilities. Much of what one needs to know about the stock market can be found by just thinking about it.

That said, here's links to some of the studies: Here, here, here, here, and here. One can easily follow these citations for even more studies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.