Dollar cost averaging is the term used by the investment industry to describe the effect of making a number of securities purchases over a period of time.
The idea is that, if you buy 100 shares of something, say a particular stock, in 10 installments of 10 shares each over 10 months, for example, your cost for the 100 shares you wind up owning in the end will be the average price you paid for all of the shares.
This seems pretty simple, and it is. Actually, this is always the case: the average cost per share of any collection of shares you own is always the aggregate cost of the lot divided by the number of shares in the lot. The timing of the purchases has nothing to do with computing their average cost.
This method of accumulating shares of stock, or other investment assets, has been advocated for decades by the investment industry, and seems to be viewed as some sort of magic investing potion by some investors. It is not unusual, in my experience, for an investor to favor, or at least assume that it will be beneficial to their interests, to spread the purchase of securities out over a series of transaction, rather than buy the entire lot at one time.
I have no doubt that this bias is the direct result of the recommendations to which these investors have been exposed, rather than to any careful analysis and consideration. I can’t think of a single time when a client of mine who questioned the wisdom of my recommendation to buy a lot of shares now, rather than wait, could explain a sound rationale for their hesitation.
If you’re on a train, and you realize that it’s not going where you’d like it to go, how long do you think you should wait to get off of that train and get on one that is going your way? Not any longer than necessary, I hope. I suspect that the thing that most inspires investor hesitation is fear – fear based on uncertainty. Either the investor isn’t sure that the move to buy the securities is the best move to make, at the time, or they are not certain that they can afford to be wrong if the value of the shares moves down, instead of up, after they are bought. Both of these concerns are legitimate reasons for hesitation, but unfortunately, neither of them will be neutralized by dollar-cost averaging.
My gripe with dollar cost averaging isn’t that it isn’t real. It is. It’s that it doesn’t do what many investors think – or what many investment pundits imply – that it does. The cure for the hesitation is to cure the fear. The cure for the fear of doing the wrong thing is to make sure that the thing you are about to do is the right thing; the best available option. The cure for the fear of being unlucky is to make sure, in advance, that you can afford some bad luck… that your financial plan can tolerate the bad luck that your investment strategy will inevitably produce. Trying to insulate yourself from these risks using dollar cost averaging is a lot like handing a band aid to a heart attack victim. It just not going to get the job done.
In addition to being less than effective at what it’s often expected to do, dollar cost averaging is also a poor bet. Yes, the average cost of the shares you buy using dollar cost averaging will always be lower than the most expensive shares you bought. But, it will also always be higher than the least expensive shares. And, given that the future cost of any share that you’d like to buy is more likely to be higher in the future than lower (if not, why are you buying it?), waiting to buy shares tomorrow that you could buy today is more likely to work against you than in your favor.
Dollar cost averaging is more likely to hurt investment performance than to help it. Investing is a game with few certainties, so doing everything you can to skew the odds in your favor is critical to achieving predictable results. If they’re the right shares to buy, and you’ve allowed for the risk that the price could go lower after you buy them, then waiting to buy shares with the hope of buying them at a lower price later is a mistake you should avoid.