Should you invest using dollar cost averaging?
I’m frequently asked if you should invest all your money now or do it slowly over a period of time? Dollar cost averaging (DCA) just means doing the latter, rather than in a lump sum all at once. DCA does not make good financial sense but is psychologically useful.
I’ll explain with a simple example.
Assume you’ve saved $6,000 that you want to invest in a Roth IRA. You’re considering two approaches:
- Invest all $6,000 tomorrow.
- Invest $500 per month for each of the next 12 months, while holding the remainder in a savings account.
#2 is DCA.
#1 is a bit more financially sensible.
Why? On average, you should expect your investments to go up over time. If you leave the money sitting in a low-yield savings account while you slowly add to your IRA each month, you’re missing out on some of the likely growth you would expect to earn. DCA should result in a slightly lower return because it is taking longer to get all of your funds invested. Is it a significant amount? No.
However, DCA can be effective to get you to consistently save money and this is an important psychological benefit. Our human minds get anxious when it comes to investing our life savings. We’re fearful that we’ll invest our funds and then tomorrow, the stock market will crash and we’ll be filled with regret and self-loathing.
DCA directly addresses these feelings because if the stock market crashed after this month’s investment, you’ll be investing again next month at lower prices and averaging down your investment cost (hence, the term). This will minimize the anxiety you may feel and allow you to continue to make the monthly investments without hesitation. Thus, a DCA strategy is greatly beneficial from a psychological perspective.
If you participate in a 401K at work, you’re already doing DCA. That’s the classic example where you contribute a small amount from each paycheck throughout the entire year.
From a narrow financial perspective, I don’t recommend DCA; instead, you should invest all your funds when they’re available.
But psychology matters greatly in personal finance so opting for a DCA approach may serve you better over the long term. It will cost you little and may empower you to become a more consistent saver. If that’s the case, the small cost will have been well worth it.