Dollar-cost averaging (DCA) was first popularised by Benjamin Graham in his 1949 book The Intelligent Investor. Since then, it has remained to be one of the most commonly used trading strategies with a lot of success. It’s not without fault, though, and many who use DCA strategies have experienced various downsides.

This article will highlight some of the pitfalls of dollar-cost averaging and why they occur. The point is not to discourage its use, but rather to make you aware so that you avoid the same mistakes.

What is Dollar-Cost Averaging (DCA) Anyway?

Before we delve into the problem(s) with DCA, it’s important to first understand how the system works. The simplest way to describe it is as an investment strategy involving making regular investments of the same amount over a period of time regardless of the market conditions.

It works based on the principle that markets fluctuate constantly. Therefore, by investing the same amount, you buy more shares when prices are low and fewer when prices are high. By averaging the highs and lows, you get to invest profitably over the long term compared to a reactionary trader.

So, What’s the Problem?

The principles of DCA are straightforward, and its performance has been proven over the decades, yet there are still issues with its use such as:

The Emotional Dilemma

Employing a DCA strategy will put you through a harrowing emotional rollercoaster. Imagine having to hold on to financial assets during a financial downturn and, worse, buying more of the same when everyone else is selling.

It takes a lot of courage to stick with the system through the ups and downs because it goes against every human instinct. Unfortunately, most people are unable to do so, which is when DCA fails as you try to change strategies.

The Opportunity Cost

The entire premise of DCA is built on the notion that you should invest more when prices are lower. Should you abandon your investment in an asset that has dropped in value, you miss the opportunity to acquire more shares at a lower price, which is the cornerstone of DCA.

To illustrate this problem, let’s consider a hypothetical scenario. You decide to invest in a popular tech company, and over several months, you stick to your DCA plan. However, when the tech sector faces a downturn, the value of your investment decreases.

Fearing further losses, you decide to stop your regular investments in the stock to avoid further losses. Had you continued with your DCA approach during the downturn, you would have been buying the stock at a much lower price, lowering your average cost. But by halting your investments, you’ve missed the opportunity to accumulate more shares at this discounted rate.

In other words, if you’re not ready to continue buying when prices are down, there’s little point in employing the DCA strategy, and it might be a better idea to invest a lump sum from the beginning.

A Cognitive Fallacy

More recent data has shown that dollar-cost averaging isn’t all it’s cracked up to be. Far from being a seemingly perfect trading strategy, its success has been attributed to a hidden bias by proponents of the system. They have been found to buy more assets when prices are about to fall and vice versa, thereby exacerbating the system’s effectiveness.

Because of this, DCA does not always generate higher profits than other strategies as previously claimed. Although this doesn’t mean that DCA is flawed, it’s important for investors to recognise this bias and use the system with full knowledge of what it can (and cannot) achieve.

The Alternative: Lump Sum Investment

In such situations, a lump sum investment may make more sense. With a lump sum, you invest your entire intended amount at once. This approach can be effective when you believe in the long-term potential of the asset and are willing to ride out the short-term fluctuations. It eliminates the emotional turmoil associated with DCA and ensures you fully benefit from lower prices during market downturns.

Conclusion

Dollar-Cost Averaging is a strategy that can be highly effective when executed consistently and without emotions. However, the emotional element of investing is often the undoing of many DCA plans. When investors lose confidence in a falling asset and halt their contributions, they miss out on the very advantage that DCA is designed to provide: buying more at lower prices. In such cases, it might be more prudent to consider a lump sum investment approach from the beginning, provided you have a strong conviction in the asset’s long-term potential. Ultimately, the key to successful investing, whether using DCA or lump sum, is to remain rational and disciplined, avoiding emotional decisions that can hinder your financial goals.