Everything you need to know about Dollar Cost Averaging

In this article, we discuss why you may want to consider dollar-cost averaging, and how the Vested app can help.

Why should you consider dollar cost averaging?

Automatic recurring investments can be beneficial in two ways:

  1. Reduce volatility of returns 
  2. Remove the mental burden of deploying capital

Reducing volatility of returns

Automatic recurring investments can be beneficial in two ways:

There are multiple points of view on the benefits of dollar-cost averaging. Some say it’s worse for returns, others say it’s better. As is with most things in life, the true answer is it depends.
Dollar-cost averaging is better for returns when the market is declining and is worse when the market is up
. Imagine two hypothetical investment scenarios that consist of 5 investing periods.

When the market is in a decline

Table 1: Lump sum investment vs. dollar cost averaging (DCA) when the market is in decline

In Table 1, we present a simplified investing scenario where the market is in decline. In this scenario, you can either invest $1,000 up front in a lump sum, or dollar cost average (DCA) into the market at a pace of $200 per investing period. At the end of five periods, the DCA approach comes out on top, yielding $916 (vs. $847 had you deployed the investment as a lump sum).
See Figure 1 for an illustration. The orange line (for lump sum investment) ends up being lower than the dark blue line (for DCA).

Figure 1: DCA vs. Lump sum investment in a declining market

When the market is going up

Table 2: Lump sum investment vs. dollar cost averaging (DCA) when the market is going up

You can do the same exercise for when the market is going up. In Table 2, we present a simplified investing scenario where the market is going up. Similar to before, you can either invest $1,000 up front in a lump sum, or dollar cost average (DCA) into the market at a pace of $200 per investing period. At the end of five periods, the DCA approach comes out below, yielding only $1,088 (vs. $1,167 had you deployed the investment as a lump sum).
See Figure 2 for an illustration. The orange line (for lump sum investment) ends up being above the red line (the DCA approach). Note, however, that this simplified approach does not take into account the negative impact of inflation on the cash holding, which would further reduce the real returns of the DCA approach.

Figure 2: DCA vs. Lump sum investment in a market that is going up

Do you now see why both opinions are true? The lump sum approach is better if the market is going up, but DCA is better when the market is down. The problem is, it’s hard to know how the market will behave in the future. You can try to time the market, but that, more often than not, leads to subpar returns.
To extend beyond the simplified examples above, you can run simulations to see if the above observations hold. Investing is path-dependent – the outcome varies depending on when you start, and how often you invest. In their paper, Kirby et al, ran a simulation of one million possible investing pathways, comparing the outcomes for the lump sum approach vs. the dollar cost averaging (DCA) approach. The result is shown in Figure 3 below.

Figure 3 above summarizes the trade-offs between the two approaches. Notice that the orange bars (the DCA probability outcome) is narrower/tighter than the blue bars (the lump sum probability outcome). This is because the DCA approach gives the investor the benefit of time diversification, producing a more predictable outcome, at the expense of possibly lower returns. In contrast, the lump sum approach gives a wider distribution of outcome; depending on when you start, you can either outperform or underperform the DCA approach.

Removing the mental burden of deploying capital

The old saying of buying low and selling high is easier said than done. Most people are afraid to buy low in fear of catching a falling knife (loss aversion). By enabling automatic programmatic dollar-cost averaging (DCA), we can remove the mental burden and remove emotion from the capital deployment process.

How does Recurring Investments at Vested work?

  1. Pick the investment you want to invest in on a recurring basis (either a stock, ETF, or Vest)
  2. Set up the buy order (order size, start date, and recurring frequency)

Once you’ve set up the recurring investment, you can always manage them in the Profile section. The recurring investments can be canceled at any time.

Was this post helpful?

Ready to begin your US investment journey?

Sign up with Vested today.

Sign up now

Our team members at Vested may own investments in some of the aforementioned companies/assets. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio. Note that past performance is not indicative of future returns. Investing in the stock market carries risk; the value of your investment can go up, or down, returning less than your original investment. Tax laws are subject to change and may vary depending on your circumstances.

This article is meant to be informative and not to be taken as an investment advice, and may contain certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, without limitation, estimates with respect to financial condition, market developments, and the success or lack of success of particular investments (and may include such words as “crash” or “collapse”). All are subject to various factors, including, without limitation, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors that could cause actual results to differ materially from projected results.

This video is meant to be informative and not to be taken as an investment advice and may contain certain “forward-looking statements” which may be identified by the use of such words as “believe”, “expect”, “anticipate”, “should”, “planned”, “estimated”, “potential” and other similar terms. Examples of forward-looking statements include, without limitation, estimates with respect to financial condition, market developments, and the success of or lack of success of particular investments (and may include such words as “crash” or “collapse”.) All are subject to various factors, including, without limitation, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors that could cause actual results to differ materially from projected results.

%d bloggers like this: