Dollar cost averaging is the practice of investing the same amount of money at regular periodic intervals. For example, a person might invest $300 every month. It's generally thought to be a good practice, but some call it a marketing gimmick, and others call it a losing proposition. Which is true? As with most debates, each viewpoint has some truth to it. Let's look at each.
Why it's a Useful Tool
The benefit of dollar cost averaging is this: by investing periodically, you're more likely to buy shares when prices are low. The low-priced shares give you the greatest return.
As an example, let's look at investing in a stock for which the price was $10 in month #1, rose to $15 in month #2, fell to $5 in month #3, and returned to $10 in month #4. A graph of the stock prices is shown below.
The stock begins and ends at $10, and the average share price is $10.
Let's assume you buy $1,000 of the stock in each month. A graph of the number of shares purchased looks like this:
The table below shows the value of the shares purchased each period at the end of the four months. The greatest "bang for the buck" is from the shares that were purchased at the lowest price. Note that although the average share price during the four months was $10, because so many shares were purchased at $5, the average price paid per share was $8.57 (=$4,000/466.7).
Since prices tend to fluctuate, buying periodically creates the opportunity to buy shares at lower-than-average prices.
Another advantage of dollar cost averaging is psychological. It takes market timing out of the picture. It is impossible to know whether the market is going up or down. Buying periodically lets you forgive yourself for not buying at the absolute low. You'll buy at close to if not spot-on the market low.
Yet another advantage, is that it meshes well with the age-old advice of "paying yourself first." Most of us invest for retirement through employer-sponsored retirement plans, where we do, in fact, dollar cost average our investments every paycheck. Periodic investing is a great way to save for retirement, education, or any other long term financial goal.
Why it's a Bad Idea
Dollar cost averaging is sometimes suggested as a way to invest a lump sum. Let's say you just received a bonus of $4,000, and you decide to invest it in the stock described in the above table. If you invest it all at once at $10/share, at the end of the four months, you'll have $4,000. If you invest it $1,000/month, as above, at the end of the four months, you'll have $4,667. But stocks tend to rise (despite the last few years), so the example above would be more realistic if the share price trended upwards. If the final share price had risen to $11.66 (=$4,667/400), then the lump-sum investment would have been as profitable as the dollar cost averaged.
Transaction fees can quickly erode the advantage of dollar cost averaging. No-load mutual funds with low minimum reinvestment values are a good choice to avoid this problem.
The financial advantage of dollar cost averaging can be overstated. In the above example, the stock price is fluctuating 50% per month. That's not an investment -- it's a roll of the dice! And our hypothetical investor only came out 17% ahead (=$667/$4,000). Lower volatility results in a lower return, as seen in the graph below. If the maximum and minimum price of the stock differ by only 10% of the average (instead of 50%), then the return from the dollar-cost averaged example above drops to less than 1%.
When financial companies tout the wonders of dollar cost averaging, they can use it to get you to sign up for a periodic investing program. Whether this is a good thing or bad depends more on the underlying investment (low cost index funds vs. pork belly futures) than on the mathematics of dollar cost averaging.
Like many investing concepts, dollar cost averaging can be a useful tool, when appropriately applied. Personally I think investing monthly (or bi-weekly or quarterly) is a good idea but primarily because it puts your investing on autopilot. Put your thought into what to invest in and worry less about when to invest in it.