Dollar Cost Averaging (DCA) Investing Strategy In Depth - To Use Or Not To Use
- by Monica J. Weissmann, CFP, CIM, MEE
Investopedia describes Dollar-Cost averaging (DCA) as an investing the same amount of money in a target security (which may be a stock or an ETF or any traded entity) at regular intervals over a certain period, regardless of price.*
If you are working for a company which is matching your contributions to a registered account (a Group RRSSP or Retirement Pension Plan) you are already practicing dollar-cost averaging, by adding to your investments with each paycheck.
Investing is a privilege, and you should only invest what you can afford to lose. If you are short on cash, looking to buy a home, have mouths to feed, or generally just not in the best place financially, then investing your money might not be the best decision in that very moment.
Otherwise, the “time in the market versus timing the market” is always right.*
The main objective of using DCA (Dollar-Cost Average) or EDCA (Enhanced Dollar Cost Averaging) strategy is to get a lower cost on every unit of your investment, over time. Depending on your personal circumstances this is achieved most of the time but is not a “one size fits all” type of solution. Two common alternative strategies to DCA are value averaging (VA) and lump sum investing. Unlike DCA, these strategies require a hands-on approach and yes, market timing. Using value averaging (VA), you would purchase less when a stock price is high and more when the price is low. Sometimes this strategy is called Enhanced Dollar Cost Averaging (EDCA).
The EDCA strategy invests a fixed additional amount after a down month and reduces the investment by a fixed amount after an up month. Specifically, it invests an additional $Y in month t+1 if the return in month t is negative, and invests $Y less in month t+1 if the return in month t is positive.* One disadvantage of dollar-cost averaging is that markets tend to go up over time. Thus, investing a lump sum earlier is likely to do better than investing smaller amounts over a long period of time.
However, using the DCA one can mitigate the adverse effects of temporary fluctuations of the market and be able to invest and get positive investment returns despite personal aversion to market volatility. Using EDCA may improve the returns even more, but the additional impact percentage wise would be limited.
The main conclusion should be “Don't Wait For A Market Decline To Invest”*. Statistically, lump summing everything as soon as you can is better; but if the length of the DCA is not excessive (less than one year, let's say) the difference is minimal and unlikely to make or break a portfolio.
Then, why should you use DCA or EDCA? That has to do with the “gain vs loss theory”: loss aversion is an important concept associated with prospect behavior theory and is encapsulated in the expression “losses loom larger than gains” (Kahneman & Tversky, 1979). *
It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining, for the same amounts of money and the same outcomes. Should you DCA or EDCA weekly or monthly?
The answer to this question depends on your investment goals and your time horizon, which is crucial. If you're aiming for long-term growth, a monthly frequency might suit you well, allowing you to ride out short-term market fluctuations. In contrast, if you're after short-term profits, a weekly or bi-weekly frequency can help you take advantage of quicker market movements.
It's a good way to develop a disciplined investing habit, be more efficient in how you invest and potentially lower your stress level—as well as your costs.
Best to use professional advice when pondering the question of the frequency and whether to use DCA or EDCA.
I wish you a successful investing!
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References:
· “Choosing Between Dollar-Cost and Value Averaging”. Andrew Beattie, May 4, 2024.
Investopedia: https://rb.gy/kn8hxm
· “Loss aversion”. Behavioral Economics.
https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/loss-aversion/
· “Timing the Market vs Time in the Market: Is One Better Than the Other?”. Jason Novak, May 22, 2023. VektorVest
https://www.vectorvest.com/blog/market-timing/timing-the-market-vs-time-in-themarket/
· “Building a Better Mousetrap: Enhanced Dollar Cost Averaging”. Lee Dunham, Geoffrey C. Friesen. December 2011.
https://digitalcommons.unl.edu/financefacpub/26/?utm_source=digitalcommons.unl.edu%2Ffinancefacpub%2F26&utm_medium=PDF&utm_campaign=PDFCoverPages
· “Don’t Wait For A Market Decline To Invest”. KDI Investment Team, July 1, 2022
https://digitalinvesting.com.my/dont-wait-for-a-market-decline-to-invest/
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