Dollar-cost averaging is often described breathlessly as an investing technique that can pump up investor returns magically. This view of dollar-cost averaging actually contains two myths, and its real advantage is something completely different.
What is Dollar-Cost Averaging?
Dollar-cost averaging refers to investing a fixed dollar amount periodically to take advantage of stock price fluctuations. This is best illustrated with an example.
Example
Suppose that Mary saves $600 each month to invest in her favourite stock index ETF that has an average price of $30 per unit over the course of a year.
Scenario 1: No volatility
In this scenario, the ETF price stays steady at exactly $30 per unit each month. Mary buys 20 units each month for a total of 240 units by the end of the year.
Scenario 2: Extreme volatility
Now suppose that the ETF price bounces between $20 and $40 from month to month. The average price is still $30, but look at what happens to Mary’s purchases. Half of the months she buys 30 units, and the other half of the months she buys 15 units. Over a year this adds up to 270 units. Mary seems to have picked up 30 extra ETF units out of thin air.
Scenario 3: Normal volatility
A more realistic volatility level is for the ETF price to bounce back and forth between $28 and $32 from one month to the next. In this case Mary ends up with 241 ETF units. She’d rather have the extra unit, but it’s not enough to get excited about.
Myth #1: Dollar-cost averaging significantly pumps up returns.
For normal levels of volatility, dollar cost averaging gives only a small advantage over the no volatility case as we saw in the example.
Myth #2: Dollar-cost averaging is an investing technique.
Dollar-cost averaging isn’t even really a choice for most of us. We get paid periodically and save some fraction of it. Every month, quarter, or year we build up enough savings to make it worthwhile to invest. What choice do we have when investing other than dollar-cost averaging?
If Mary had come into a large lump sum such as an inheritance, she would have a choice to make. She could either choose some sensible asset allocation and invest all of the money right away, or she could spread her investment purchases over several months or years.
The truth is that the benefit of dollar-cost averaging is small compared to the lost returns from waiting to invest the money over time. A study of historical investment returns would show that, on average, Mary is better off investing the money right away.
The real benefit of dollar-cost averaging.
The real benefit of dollar-cost averaging isn’t the extra units that pop into existence through the magic of math. Investors who use dollar-cost averaging are consistent savers. If the idea of dollar-cost averaging motivates her to keep saving and investing then that’s wonderful, buy it’s the fact that Mary saves money every month that helps her finances.
Discussions of dollar-cost averaging are mostly a distraction. Their only meaningful benefit is to encourage people to save regularly.
To me the term 'dollar cost averaging' refers to intentionally buying more shares after the price has decreased - as opposed to investing a specific sum month after month, and taking whatever the price is at the time.
ReplyDeleteJust semantics, but to me the latter is not dollar cost averaging.
Nevertheless, good post.
Mark: I'm used to using the term "averaging down" for buying more of a stock after it drops. I agree that this is just semantics. It's the concept that matters.
ReplyDeleteMark: There are a number of ways to "average" the cost of your periodic investments. If you average the cost by investing a fixed number of dollars, then you're doing dollar cost averaging. Otherwise, you're using another averaging technique (such as value averaging).
ReplyDelete