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Why Dollar Cost Averaging Sometimes Works?

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I was reading about Dollar Cost Averaging over on The Digerati Life this morning and found something immediately interesting. The articles makes a good point that if you were to look at how our stock market has performed in the last year, you'd likely have some good gains with dollar cost averaging. The reason why is that you would be buying a lot of cheap stock on the dip that we had at the beginning of the year.

She illustrates this with an example from Tomorrow's Scholar, specifically with this chart below:

Dollar Cost Averaging

Does anything seem unusual about the numbers in the example? Give it a look and see if you can see what I see. The stock prices are taking the same "V" pattern. It even ends in a positive note, so the look extra nice. This means that the average you've buying at is lower than today's price as long as it gets back to where it was (or goes a little higher). This isn't what I'd call a "fluctuating" market at all. It has no high points where you are potentially overpaying for the stock relatively to where it ends up.

Ahhh, Data, you are a kooky and wonderful thing. You are like Play-Doh flexibly bending to into a different creations in the hands of many.

What would happen if you took a snapshot where the stock was rising up and then dropped to a level slightly below where it started. This is the inverse of the "fluctuating" market above. In this scenario you'd find that every step of the way you were "overpaying for the stock" relative to where it ends up. In this scenario you'd lose money with dollar cost averaging.

Now what The Digerati Life showed was very valuable. The chart she found is more or less exactly what the market did in the last year - which proves her point exactly. However, if you chose to dollar cost average into the opposite scenario that I outlined, (say technology stocks from 1998 through 2001), you'd probably come away with a different opinion. Who is to say the next year isn't going to see growth before another drop-off?

I'm not trying to say that dollar cost averaging is bad. I do it myself because I believe in systematically putting system away. However, it can be important to question the data and see if it truly makes sense.

Posted on September 24, 2009.

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7 Responses to “Why Dollar Cost Averaging Sometimes Works?”

  1. If the average price is lower than the end price, you win. If the average price is higher than the end price, you lose. It’s as simple as that. As you noted, you can always find data to “support” either argument. Dollar cost averaging is mainly promoted by those who make a commission on each investment and in particular wishes to do so on a regular basis.

  2. Of course, it doesn’t always work out perfectly — DCA works well when the end point is a rising trend/market. But so far, in the big scheme of things, the US stock market has only really gone up in a big way, despite the massive hiccup of the last decade. I had another article that showed exactly the technicalities of DCA which I linked to from that post. The strategy is not perfect but it’s worked so far if you had started this process when things were much lower (say when I did, in the early 1990’s). Also you’re better off having done this than having bought lump sum at the peak. You’d be up the creek then.

  3. MLR says:

    I also dollar cost average but you need to remember to always look at the fundamentals.

    I’m glad you raised this question about the data shown above because it was obviously created to fit an argument. I like when arguments are created based off of data :)

  4. plonkee says:

    It’s only really dollar cost averaging if you have a lump sum that you could invest all at once, but instead choose to invest in small lumps over several months.

    Most of the time, people are investing from their regular income. It’s not exactly like they could choose to do something else – it’s regular investing, rather than trying to average over time.

  5. In any conversation about dollar-cost averaging, I feel it’s my duty to bring up value averaging. It’s a little more sophisticated and nuanced that DCA.

  6. Plonkee is right. Dollar-cost-averaging is the only thing most people can do.

    If you knew what the shape of the stock market would be like (the V) then dollar cost averaging sucks because you should have invested everything at the bottom of the V. But if you didn’t know what the curve looked like in advance and dollar-cost-averaged then your shares will cost on average less than the average cost of the shares over the same time period. That’s just because you buy more shares the cheaper they are.

  7. I agree with Plonkee and Customers Revenge. DCA is the best option available to me to invest my funds and so far it has worked out quite well for me. It is also a way for me to diversify my portfolio. For e.g. if I am able to set aside $500 a month to invest in individual equities, I would spread that across a few stocks rather than a single stock. I would repeat that every month, investing a smaller portion in several stocks versus a single stock. Contrary to a comment someone made, DCA does not always have to be more expensive (due to commissions). There are many companies that let you purchase stocks directly (without a broker) on a regular basis for no fees or minimal fees.

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