Dollar cost averaging


Dollar cost averaging

Dollar cost averaging (DCA) is an investment strategy that may be used with any currency. It takes the form of investing equal monetary amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.[1]

Dollar cost averaging is also called the constant dollar plan (in the US), pound-cost averaging (in the UK), and, irrespective of currency, as unit cost averaging or the cost average effect.[2]

Contents

Parameters

In dollar cost averaging, the investor decides on three parameters: the fixed amount of money invested each time, the investment frequency, and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sum investing. One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.[3]
One key component to maximizing profits is to include the strategy of buying during a downtrending market, using a scaled formula to buy more as the price falls. Then, as the trend shifts to a higher priced market, use a scaled plan to sell. Using this strategy, one can profit from the relationship between the value of a currency and a commodity or stock.

Return

Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested is[4]

r = \frac{p_F}{\tilde{p}_P} - 1,

where pF is the final price of the investment and \tilde{p}_P is the harmonic mean of the purchase prices. If the time between purchases is small compared to the investment period, then \tilde{p}_P can be estimated by the harmonic mean of all the prices within the purchase period.

Criticism

While some financial advisors such as Suze Orman [5] claim that DCA reduces exposure to certain forms of financial risk associated with making a single large purchase, others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.[6]

Middleton claims that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.[7]

Confusion

Discussions of the problems with DCA can do a disservice to investors who confuse DCA with continuous, automatic investing. Unfortunately this confusion of terms is perpetuated by many sources discussing automatic investing (such as AARP[8] and Motley Fool[9]). The argued weakness of DCA arises in the context of having the option to invest a lump sum, but choosing to use DCA instead. If the market is expected to trend upwards over time[10], DCA can conversely be expected to face a statistical headwind: the investor is choosing to invest at a future time rather than today, even though future prices are expected to be higher. But most individual investors, especially in the context of retirement investing, never face a choice between lump sum investing and DCA investing with a significant amount of money. The disservice arises when these investors take the criticisms of DCA to mean that timing the market is better than continuously and automatically investing a portion of their income as they earn it. For example, stopping one's retirement investment contributions during a declining market on account of the argued weaknesses of DCA would indicate a misunderstanding of those arguments. The argued weaknesses of DCA do not arise because attempts at timing the market tend to be effective, but because investing in the market today tends to be better than waiting until tomorrow. Applying that knowledge to the average retirement investor's situation would actually support - rather than contest - a policy of continuous, automatic investing without regard to market direction.

References

  1. ^ Chartered Retirement Planning Counselor Professional Designation Program, College for Financial Planners, Volume 9, page 64
  2. ^ "Durchschnittskosteneffekt". http://de.wikipedia.org/wiki/Durchschnittskosteneffekt. Retrieved 2009-01-12. 
  3. ^ Jones, Bill. "Do Not Dollar-Cost-Average for More than Twelve Months". http://www.efficientfrontier.com/ef/997/dca.htm. Retrieved 2009-01-05. 
  4. ^ "Derivation of the dollar cost averaging return formula". http://tsp.peacefulgains.com/Derivation-of-the-dollar-cost-averaging-return-formula/. Retrieved 2009-01-05. [dead link]
  5. ^ http://www.suzeorman.com/dt/calc_dollarcostaverage1.cfm
  6. ^ Middleton, Timothy (2005-01-04). "The costly myth of dollar-cost averaging". http://web.archive.org/web/20050910142530/http://moneycentral.msn.com/content/P104966.asp. Retrieved 2009-01-05. 
  7. ^ "Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk". http://beginnersinvest.about.com/cs/newinvestors/a/041901a.htm. Retrieved 2009-03-22. 
  8. ^ "The hidden benefit of an automatic investing program". http://www.aarpfinancial.com/content/YourGoals/savForRet_hdnBenefitAutoInvest.cfm. Retrieved 2009-05-02. 
  9. ^ "Don't Make a Million-Dollar Mistake". http://www.fool.com/investing/mutual-funds/2008/12/21/dont-make-a-million-dollar-mistake.aspx. Retrieved 2009-05-02. 
  10. ^ "Long Term Returns (a survey of studies)". http://dailyspeculations.com/scholarly/LongTermStockReturns.html. Retrieved 2011-03-13. 

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