Is there a limit to the effectiveness of dollar-cost averaging when dividing up purchasing events?

Question

If buying $12,000 worth of low-cost index funds, let's say that I buy $1000 per month for a year, instead of buying $12,000 all at once. From what I understand, this makes it more likely to improve investments over the long term. But what happens if you take that to its extreme (not accounting for brokerage fees at each purchasing event), by buying about $230 per week or even $33 per day? Would that eliminate/increase/decrease the effectiveness of the dollar-cost averaging strategy? Could it increase its effectiveness, but at a diminishing rate of increase?

Answer 1

There are two ways that Dollar-cost-averaging are better than a lump sum.

• To provide a method of investing if the investor has a very large fear of making the worst possible timing decision. If that fear means that they spend months agonizing over how to make their investment, and they miss years of potential growth while waiting for the perfect moment that will provide guaranteed growth, with zero risk; then DCA allows the to invest in a way they are comfortable with.

• DCA is also the way most people invest their money into retirement funds. In the US it is into a 401(k), but other countries also have retirement or pension funds funded this way. In the US there are IRAs that many fund in a annual payment, but those can also be funded in smaller periodic amounts.

Some argue that paycheck contributions to a 401(k) aren't DCA, but they are because they allow a person to invest small amounts periodically without waiting until they have accumulated a lump sum to meet some initial investment level.

In the first situation I think that daily small investments would be overkill. Monthly or with every paycheck would be enough to overcome the fear of making a bad choice.

In the second situation per paycheck works fine. I guess you could put the contribution into the fixed income portion of the 401(k), and then every day login and move some money into one of the mutual fund options. Most people would consider that too much work. This also wouldn't address the biggest fear 401(K) participants have to starting out. They have a hard time with the concept that if I put this money into my retirement fund when I am 22 what happens if I need it when I am 25?

Answer 2

One small correction. The market is open about 250 days a year so for daily purchases, you would invest $48 per day.

The effectiveness of dollar cost averaging depends on the price behavior of the stock/fund. If the long term trend is up, you're better off with an annual purchase because you get the highest number of shares per year. OTOH, if the long term trend is down, shorter term purchases will outperform.

As a simple example, a fund is $100. It rises $1 per week, linearly. The annual purchase nets 120 shares on day one. Because share price is rising, the weekly purchase buy fewer shares each week, perhaps about 100 shares by the end of first year. Advantage: annual purchase. For a trending down year, it's the opposite.

Although stocks can appreciate linearly, occasionally, there are aberrant periods. Imagine if your annual purchase was in early February this year, just before the market tanked 35%. Then, the advantage would go to shorter term purchases.

The short answer? It depends.