DOLLAR COST AVERAGING—LOWER RISK, BETTER RETURNS
What is dollar cost averaging (DCA)? It’s investing periodically a little at a time. But isn’t that what you do with your 401(k)? You sock away a little each month, probably (hopefully) if you are maxing out your 401(k) each year (which most all of you should be doing).
Not entirely. Folks portion out their 401(k) contributions because they usually don’t have the cash flow all at once to max it out in one month, so they do it periodically. And the IRS limits how much you can contribute each year, so you’re forced to spread contributions out over a long time. DCA is different—when folks have a big boodle to invest, instead of plunging headlong into the market, they often do smaller lumps, spread over time. The theory is DCA protects you from investing it all on a “bad” day. Maybe you accidentally invest at a relative high—just before a big correction. Or worse—at the top of a bull market. We all know we don’t want to “buy high.” Dollar cost averaging reduces the risk of getting “all in” on a bad day—spreading out your cost basis over time.
And yes—it does do that. But does that actually improve your returns over time? Probably not. But it definitely increases transaction costs—that alone reduces your performance.
DCA—A Fee Bonanza
DCA goes in and out of favor. When markets are strongly rising for a long time, like in the late 1990s, people tend to forget their fear of the “bad” day. DCA usually comes surging back in popularity ...