There are two types of Dollar Cost Averaging (DCA). Automatically saving in your employer’s 401(k) is the good version. The investor is systemically purchasing shares which will have a smoothing effect over time i.e. buying more shares when the market is down & buying less when the market has appreciated. The best part about this approach is there is no guesswork. The saver automatically defers part of their pre-tax income to their 401k.
The problematic version is an investor or advisor sitting in cash and looking to get the funds fully invested. DCA investors can be left holding cash and missing out on hefty returns during market melt ups. DCA is a good idea in theory, but if executed incorrectly it can derail investment returns.
Dollar Cost Averaging- Dollar-cost averaging (DCA) is an investment technique of buying a fixed dollar amount of an investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high. Source: Investopedia.
Not All DCA Plans Make Sense
For simplicity, we can assume the investor has their risk tolerance and target asset allocation figured out (for this example let’s use a 60% equity/40% fixed income portfolio). Note: we assume getting fully invested in our 60/40 allocation is the optimal approach. Typically, the longer we hold cash, the longer we delay reaching our optimal portfolio.
Following are commonly used DCA approaches (ranked worst to best):
Price Approach (worst)– cash is invested only when the desired price target is met, i.e. waiting until the S&P 500 dips to 2,000. This has the highest potential cost and can be disastrous for long term planning. Countless investors/advisors peg an arbitrary price as a trigger to get fully invested. The result can have expensive consequences with potential to miss out on outsized equity returns.
Calendar Approach– cash is invested over a predetermined timeframe, i.e. investing systemically over the course of 12 months. This is probably the most straightforward approach and has a low expected cost to the investor.
Halfsies Approach– 50% is immediately invested into our 60/40 portfolio. The remaining cash would be deployed over a fixed time period (similar to the calendar approach).
Risk-Based Approach (best)– fully invest the “safe” asset classes first. In our 60/40 example, we would fully invest the fixed income immediately. For the riskier assets (stocks), we use a shortened version of the calendar approach. Rather than investing over the course of 12 months, the equities would be fully invested within three months. We would be more aggressive with purchasing beaten down areas of the equity markets. For example, in today’s market environment, we have been more aggressive in allocating cash to international developed (especially Europe) and emerging market equities (we are exercising more prudence with U.S. markets).
Any of the above DCA approaches (with the exception of the Price Approach) will not move the needle dramatically for long-term investors. However, DCA is often misapplied in practice by do-it-yourself investors and novice advisors, leading to sub-optimal investment results.
Clear communication between advisor and client on the DCA timeline and strategy is paramount. If cash is going to be held for an extended period (>30 days), the investor should not pay fees on the dormant cash balance. We encourage clients to keep any “cash buffers” in their bank accounts to avoid paying their investment manager to hold the money.