Dollar cost averaging means investing a set amount on a schedule, for example $500 a month every month.
Dollar cost averaging isn’t the same as periodic investing. Dollar cost averaging means you have the cash to invest in a lump sum now but you choose to phase in your purchases over time. Periodic investing means the money you invest hasn’t been earned yet; as you earn the money, you invest, like you do in a 401k account.
Dollar cost averaging helps smooth out the price fluctuations. If the price drops, you buy more shares. If the price rises, you buy fewer shares. It also helps minimize regret for having poured everything into an investment when the price was high.
That’s the theory. In reality, sticking to the schedule isn’t as easy as on paper. Prices often have momentum in the short-term, although it’s hard to predict when the momentum turns the other way. Price momentum often throws a dollar cost averaging plan into question.
Suppose you start your dollar cost averaging with $500 a month and prices keep going up three, four, five months in a row. You see you are buying fewer and fewer shares with your $500. Do you feel the urge to dump the rest of your money into it now, lest you buy fewer and fewer shares in the coming months? If you do, you just abandoned your dollar cost averaging plan together with its theoretical benefits.
On the other side, suppose you start your dollar cost averaging with $500 a month and prices keep going down three, four, five months in a row. You see the shares you bought so far have lost value. Do you feel the urge to suspend your purchases and wait for it to bottom out?
Suppose you do suspend your purchase and the price drops again, you feel pretty good about your decision. Now the price comes up a little. Do you resume or do you keep suspending your purchases? If you resume, you are afraid the price will drop again. If you wait, you are afraid you will miss the bottom. Either way, you just abandoned your dollar cost averaging plan together with its theoretical benefits.
Here’s another thought experiment. Suppose over 12 months, the price of an investment:
(a) goes up by 50% in the first six months, then down in the second six months, finishing the year up 20%; OR
(b) goes down by 50% in the first six months, then up in the second six months, finishing the year down 20%
If you invest a lump sum, it’s easy to see that you make 20% under (a) and you lose 20% under (b). If you dollar cost average over this 12-month period, how will your dollar cost averaging turn out at the end of 12 months under each scenario?
You will make 3% under (a) but you will make 30% under (b). You make a lot more money under (b) although the price went down from 100 at the beginning of the year to 80 at the end of the year because you were able to buy more shares at lower prices. More shares at 80 are still worth more than fewer shares at 120.
Therefore, when you dollar cost average, don’t stop buying on the way down.
I say this partly as a reminder for myself. I set a schedule to add to my investment in a muni bond fund every month. In recent months, prices of muni bonds have been going down. I kept the schedule so far but it isn’t easy.