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Dollar-Cost-Averaging is Your Friend

Many investors with cash on the sidelines have been gritting their teeth as they’ve watched the lows of March turn into an impressive rally.  While you may have missed a market bottom, there are still gains to be made.  It isn’t too late to put your cash to work in the market.  The question then becomes, what’s the best way to do so? 

In his recent quarterly letter, Jeremy Grantham writes that investors must force themselves to invest in a cheap market even when afraid of falling prices.  If you missed the earlier lows, he writes, “grit your teeth and phase slowly into a cheap market.  You can’t gamble that it will oblige you by another low.

Lump-sum vs. Dollar-Cost Averaging

Lump-sum investing is pretty much as it sounds – you take a lump sum of money and invest in all at one time across one or multiple investments, locking in your portfolio cost-basis at one snapshot of time in the market.  The trick is that our natural tendency is to hope that we’ve picked a good time to do so.  One can’t help but ask if one has picked a good time (or even worse, “the” good time) to put our precious cash to work. 

Dollar-cost averaging is the practice that one invests a set amount of money in the same group of investments on a recurring basis.  401(k)s come to mind as a vehicle that support this practice well.  Participants in 401(k) plans generally devote a set percentage of their salary to a group of investments on a monthly or bi-weekly basis.  Assuming a consistent salary and/or company match, the dollar amount invested will be consistent, but the number of shares purchased for the individual investments will vary as individual investment prices fluctuate over time.   

Why Might Dollar-Cost Averaging Be Better?

Dollar-cost averaging (DCA) removes much of the guess-work in picking a good time to invest.  With the discipline of continuous investment, the prices of any one day become significantly less relevant as your overall cost basis will be an average of each of the recurring investments you’ve made over the entire period of time you have been dollar-cost averaging.  Better yet, with dollar-cost averaging, market fluctuations can work to your favor.  With lump-sum investing, after the investment has been made, we sit back and wait for appreciation.  With dollar-cost averaging, price declines can benefit your portfolio as well.  As prices fall, we continue to invest the same amount of cash on an ongoing basis, so we’re able to buy more shares of our investments at a lower cost.  Conversely, when prices are high, we’re buying relatively fewer shares. 

We all know that portfolio diversification is an important element of investing.  Consider dollar-cost averaging a way to diversify your cost-basis.

A Caveat: Cost
While there are numerous advantages to dollar-cost averages with respect to diversifying cost basis and mitigating price risk, it is important to consider the costs involved with this strategy.  If you will be required to pay transaction costs for each time you invest, dollar-cost averaging may not be appropriate for your particular account.  Fees eat at portfolio returns and the subsequent transaction costs of dollar-cost averaging may resoundingly outweigh the benefits.  Aforementioned 401(k) plans work well, as do accounts in which an Automatic Investment Plan (AIP) is offered.  Otherwise, you may want to consider a hybrid of lump-sum and dollar-cost averaging in which you invest multiple lump-sums several times a year.  The amount and frequency will vary from individual to individual, as one weighs the cost of transaction fees for the peace of mind of putting cash to work in a more systematic manner.

Tweaking Your Dollar-Cost Averaging

For those investors who have the itch to juice returns with some subtle market-timing, all is not lost with DCA.  While the textbook definition subscribes to the contribution of the same amount to the same investments on an on-going basis, the practical execution can be adjusted as you see fit.  Consider for example, setting a baseline contribution amount or percentage for your 401(k) or AIP.  In times of prolonged market downturn (e.g. 2008 – Q1 2009), you can opt to ratchet up your amount contributed to take advantage of less expensive share prices.  As market conditions improve, pare back your contribution amount closer to your baseline.  The end result: you own more shares at a lower cost basis. 

Disclosure: None