What is Dollar Cost Averaging?

5/29/2024 - By Mark Hemby, CFA, CFP

The S&P 500 hit a new all-time high 22 times during the first quarter of 2024. Since 1957, the index has reached a new high every 14.3 days. These higher prices are great for investors in the market, but present a hurdle for investors on the sidelines. Let’s look at how investors should approach this hurdle to get their funds invested for the future.

There are 2 recommended approaches an investor can take when deciding how to invest idle cash: lump-sum investing and Dollar Cost Averaging (DCA). Lump-sum investing is straightforward. The investor makes a single-day transaction to buy all the investments at current market prices. Financial advisors often prefer this strategy because markets historically go up 60% of the time. Waiting to buy is likely to result in a higher purchase price in the future versus buying today. Also, even if an investor bought at higher prices today versus the future, the difference is often negated by the fact that lump-sum has been invested longer, generating dividends which can be reinvested and compound future growth. While lump-sum investing is the preferred strategy, some investors find it difficult to adopt this approach. For them, we often recommend Dollar Cost Averaging.

What is DCA?

Dollar Cost Averaging is a strategy of investing a fixed amount at regular intervals. Someone wanting to invest $500,000 might structure a 12-month buy-in, with each $41,667 purchase occurring at the beginning of each month. By consistently purchasing the same dollar amount, one acquires more shares when prices are low and fewer when prices are high. Many who regularly contribute to a retirement plan like a 401(k) are doing this without even knowing it.

Why would you use DCA?

If an investor is unwilling to use the lump-sum approach, it is likely because they fear the market is going to go down in the near-term. Ideally, we would dissuade this individual from engaging in market timing since it’s impossible to know when the market will drop. But with no strategy to buy back into the market, the investor will likely sit on the sidelines until prices drop enough to entice them to buy. This “Buy-the-Dip” approach can be catastrophic to a financial plan if the dip doesn’t materialize. For example, in 2009, as the market was on the road to recovery after the Great Financial Crisis, many investors remained in cash and were convinced a second downturn was imminent. Unfortunately for these investors, markets did not “dip” until 2018, leaving over 9 years of missed returns at an annual return of over 15% per year with the S&P 500 index . Studies have reinforced the value of DCA, comparing DCA to Buy-the-Dip by assuming that an investor has the ability to foresee every market bottom and purchase exactly then. Even with omniscient timing, the Buy-the-Dip approach underperformed DCA 70% of the time. DCA offers an alternative to buying the dip by giving an investor a structure to put their capital to use and minimize the risks of market volatility by distributing investments across various price points.

Dollar Cost Averaging emerges as a prudent strategy, offering investors a methodical approach to navigate market fluctuations while potentially yielding favorable returns over time. While it is not always the best approach for investing idle cash, it is a great option as it provides a framework for investing decisions and offers some peace of mind that you’re buying in at fair prices. If you would like to discuss this strategy in more detail, reach out to one of our advisors at Saltmarsh Financial Advisors.

About the Author | Mark Hemby, CFA, CFP®

Mark is a senior financial advisor for Saltmarsh Financial Advisors, LLC, an affiliate of Saltmarsh, Cleaveland & Gund. He holds both a Chartered Financial Analyst (CFA®) designation and a Certified Financial Planner (CFP®) designation. As part of our investment advisory group, he works with clients to develop and implement investment strategies to achieve financial freedom while also ensuring their goals and objectives are aligned. Mark has over 15 years of experience in investment banking working with individuals and organizations to manage their portfolios and coordinate investment activities. In addition to his experience with fixed-income trading and sales, Mark owned and operated his own business in Alabama.