What is dollar cost averaging (DCA)? It’s investing periodically a little at a time. But isn’t that what you do with your 401(k)? You sock away a little each month, probably (hopefully) if you are maxing out your 401(k) each year (which most all of you should be doing).
Not entirely. Folks portion out their 401(k) contributions because they usually don’t have the cash flow all at once to max it out in one month, so they do it periodically. And the IRS limits how much you can contribute each year, so you’re forced to spread contributions out over a long time. DCA is different—when folks have a big boodle to invest, instead of plunging headlong into the market, they often do smaller lumps, spread over time. The theory is DCA protects you from investing it all on a “bad” day. Maybe you accidentally invest at a relative high—just before a big correction. Or worse—at the top of a bull market. We all know we don’t want to “buy high.” Dollar cost averaging reduces the risk of getting “all in” on a bad day—spreading out your cost basis over time.
And yes—it does do that. But does that actually improve your returns over time? Probably not. But it definitely increases transaction costs—that alone reduces your performance.

DCA—A Fee Bonanza

DCA goes in and out of favor. When markets are strongly rising for a long time, like in the late 1990s, people tend to forget their fear of the “bad” day. DCA usually comes surging back in popularity in bear markets or after, when folks are particularly fearful. During boom times, the only people talking up DCA are usually unscrupulous brokers who want the vastly higher commissions relative to your total assets that come from using DCA’s dribbling-it-all-out quality instead of investing in a larger chunk. (There are plenty of fine, honorable brokers—most of them! But in an industry where folks receive commissions for sales, you naturally get some who want to increase commissions however they can.) DCA can be a major boon to brokers looking for fees. You usually pay much more commission per dollar traded on small trades than on large ones. So, when you break your lump sum up into many little pieces, the total commission paid to the broker rises markedly.
But if it’s in the interest of managing risk, maybe it’s worth it to pay a bit more. Except plenty of studies have shown that DCA doesn’t reduce risk nor improve returns. A particularly good and thorough study was done about 15 years ago by Michael Rozeff (former professor of finance at the University of Buffalo). From 1926 until 1990 (before the big 1990s bull market), he compared results from doing a single, lump-sum investment each year to averaging stock purchases over 12 months. A whopping two-thirds of the time, the lump-sum method was more profitable than DCA—just the opposite of what DCA proponents would expect or what the media normally promotes. And, for the entire period, the lump-sum approach got a 1.1 percent higher average annual return—huge when you start compounding returns.1
My firm has done our own studies more recently with similar conclusions. We compared the lump-sum investing at the beginning of a 20-year time horizon to DCA—parsing the initial investment out equally for the first 12 months—from 1926 to 2009, with the uninvested portion earning cash-like returns. By our analysis, lump-sum investing does better 69 percent of the time. And that doesn’t factor in DCA’s added transaction costs, which skew results even more in lump-sum’s favor. While folks don’t want to believe that (particularly not now in the recent shadow of the 2007-2009 monster bear market), it’s true.
People often wrongly think the 2000s was a period of flatness, because overall, stocks ended about where they began the decade. Wrong! There was big volatility along the way. And they also wrongly think because that decade ended with stocks no higher than at the beginning, the next decade will be “flat.”
Again—wrong. No one anywhere has the ability to forecast stocks that far out—not yet (see why in Bunks 10 and 20). And what just happened isn’t predictive of what will happen. But even in a period of flatness, DCA doesn’t really help at all. The interest gained from holding cash tends to largely equal the higher transaction costs. DCA really only helps if you know there’s a falling market ahead. And if you could forecast that accurately, what do you need DCA for?
Simply put: Lump-sum investing, over time, is far more likely to yield better results. Not every year, but enough to make DCA fully irrational. The reason is simple: More often than not, stocks move higher. You benefit more from being invested more of the time than you do trying to avoid near-term wiggles.
Most investors will accept that and acknowledge, long term, it’s about time in the market, not timing the market. So why, when getting down to brass tacks, do people suddenly fall prey to DCA? Simple. It goes back to what I’ve said and will say frequently through these pages. People feel the pain of financial loss over twice as much as they enjoy a similar-sized gain. Investors might be inclined to accept an inferior strategy if it can reduce the possibility of making one big mistake that makes them feel terrible in the near term.
After all, jumping all in on one bad day would cause a lot of regret. As humans, we hate feeling regret. Sometimes, investors do extremely weird and irrational things just to avoid the possibility of the pain of regret—even racking up unnecessary transaction fees and hampering long-term performance. It’s not rational, but it happens. But you can avoid falling prey by remembering your emotions are your number one enemy in investing, always.
Even if you do make a very poorly timed lump-sum investment, remember, bull markets over time overwhelm bear market losses. (See Bunk 8.) Bull markets are bigger and last longer than bear markets—and that likely continues. Put simply: DCA doesn’t work like folks want it to, and the biggest beneficiary is likely the broker, who just gets more fees. So join me now and say it: “Don’t fall prey to DCA.” It’s like a poem.
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