Connecting the dots on Dollar Cost Averaging

Dollar-cost averaging (DCA) is a popular investing technique whereby you incrementally purchase more shares of the funds in your portfolio: in small amounts on a monthly or quarterly basis. The main idea is to not invest all of your money at once: avoiding big dips in the market right after your purchase. If you only invest a little at a time, you’ll buy more shares when the market is down and fewer shares when the market is up. Sounds like a no-brainer, right? Well, DCA really only makes sense in a few cases.

In non-fund, stock heavy portfolios

If you have a portfolio that consists mostly of individual stocks (like Apple, Facebook, Twitter, etc), then dollar cost averaging is the best strategy. Individual stocks’ prices fluctuate drastically and there’s nothing worse than buying a few hundred or thousand dollars of a company’s stock only to have the stock tank shortly thereafter. Spreading your capital into monthly (maybe even weekly if you are super serious) investments is wise.

In mutual-fund heavy portfolios

If you have a portfolio that consists mostly of mutual funds or exchange traded funds (ETFs), then dollar cost averaging makes little sense, in my opinion.

For mutual funds, your (possibly mandatory) monthly contributions are already an implementation of dollar cost averaging. If you’re putting more money into your mutual funds (aside from the minimum, monthly contribution), then dollar cost averaging might not make sense, depending on the types of funds in your portfolio.

The share prices of mutual funds only fluctuate by a few cents (in most cases) at the end of every day. The extra cognitive overhead of remembering and executing the purchase of more shares every month or quarter, doesn’t seem worth the effort for saving a few dollars.

Of course, if you’re dealing with a fund that focuses on the “small-cap growth” or “emerging markets” asset categories, you’ll likely see some bigger price fluctuations. Dollar cost averaging could make sense here.

Also note, that is has been stated (according to Vanguard) that “lump-sum” investing performs better than dollar cost averaging in the majority of cases. Even with some statistical data, you’ll still hear arguments for or against DCA in books and blogs everywhere.

In an ETF-heavy portfolio

If your portfolio consists mostly of exchange-traded funds, then dollar cost averaging is still on the table for non-retirement portfolios.

In a retirement portfolio (only IRAs are considered since 401Ks don’t really offer ETFs), the maximum contribution is (currently) $5500 a year ($6500 if you’re 50 and older). In this case, dollar cost averaging only makes sense for quarterly purchases.

Spreading $5500 across 12 months is only about $458/month. If you have more than 2 funds, then $458 is not really enough to go around; you’ll at-most be able to purchase a single share of an ETF. That feels like a droplet in a bucket. Unless a fund drops in value by 50% (a market crash), what are you really saving using dollar cost averaging?

Spreading $5500 about 4 quarters in a year amounts to $1375/quarter. That’s a more sizable amount that will potentially get you a handful of shares per fund. What’s more, fluctuations in price about quarters is (likely) more noticeable to (perhaps) justify the cognitive overhead of remembering to purchase shares according to your asset allocation.

If you have a non-retirement (taxable) portfolio, then the upper-bound of $5500 doesn’t apply, so dollar-cost averaging is still a consideration if you have enough money to get more than one additional share per fund.

So what should I do?

In summary, dollar cost averaging (DCA), if considered at all, seems to make sense in the following situations:

Monthly DCA:

  • You have a (retirement or non-retirement) portfolio of one or two mutual funds or ETFs
  • You have a stock-heavy, risky portfolio

Quarterly DCA:

  • You have more than a few funds in your fund-based portfolio (if the funds are known to be volatile)

Any other situations when DCA makes sense? I’d love to hear about it.