Dollar Cost Averaging May Help You Avoid Some Market Pitfalls

(LifeWire) — Dollar cost averaging is the practice of dribbling a predetermined amount of money into investments at regular intervals, rather than plunging it in all at once.

By definition, dollar cost averaging forces you to buy more when the market price is low and less when the price is high. And thus, it forces you to follow half of the classic investment advice that can be difficult to practice without the aid of a disciplined system: buy low and sell high. (It doesn’t help with the sell high part, but it does help you buy bargains.)

Risks, Rewards of Dollar Cost Averaging

Many investment brokers and other securities salespeople argue that dollar cost averaging is the surest way to boost your returns because you are buying more shares of whatever you’re investing in during its lowest ebbs.

But academic research through the years has tended to show otherwise. If the highest return is all you are seeking, investing a lump-sum outperforms dollar cost averaging more often than not because more of your money is invested for a longer time.

More often than not, of course, does not mean always. In the 1990s, two researchers, Richard Williams and Peter Bacon, analyzed 65 years of 20th century market conditions. Their conclusion: lump sum investing would have beaten dollar cost averaging about two-thirds of the time. On average, the lump sum approach returned about 12.75% a year, compared to dollar cost averaging’s 8.5%.

But what if you are unlucky enough to plunge all of your money into the markets just before a major downturn? A DCA program spares you that risk, and that’s why it outperforms lump sum investing one out of three times.

So, there is a classic economic tradeoff involved: Take more risk with a lump-sum strategy, and your returns are likely to be higher. Lessen your risk with DCA, and you are likely to lower your returns as well.

Many investors don’t have a large pot of cash, but they can dollar cost average.

Employees who regularly invest in their 401(k), 403(b) or individual retirement accounts through payroll deductions are, in effect, dollar cost averaging.

Many mutual fund companies will waive their minimum investment rules for investors who want to start investing with them through automated dollar cost averaging programs. And many larger corporations also allow investors to set up dollar cost averaging investment plans ford their stocks.

LifeWire, a part of The New York Times Company, provides original and syndicated online lifestyle content. David Fisher is a freelance writer based in Bend, Ore. In addition to 25 years as an editor and writer he has worked as a professional financial adviser.