Dollar-Cost Averaging - What Is It?

Dollar cost averaging has many different names which include constant dollar plan, unit cost averaging, incremental trading, and cost average effect.  But they all speak to the same strategy.  Simply put, dollar-cost averaging is dividing up the total amount invested across periodic purchases.   

The act of dollar-cost averaging was first popularized by Benjamin Graham in his classic investing book, The Intelligent Investor in 1949.   

“The third device of “dollar-cost averaging,” which means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter.  In this way he buys more shares when the market is low then when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.” 

-Benjamin Graham, The Intelligent Investor 

Lump Sum vs. Dollar-Cost Averaging 

Since that writing there has been plenty of work done on dollar-cost averaging and its merits.  One area that gets much of the discussion is a comparison of dollar-cost averaging vs. investing a lump sum.  Examples would include a small business owner who recently sold his business or a widow who just received a large life insurance check.  That person wants or needs to invest this money but questions when to invest that money.   

Dollar-cost averaging provides a disciplined, systematic way to invest that sum of money.  Here the investor would pick a time horizon in which to invest the sum and divide that total amount into equal, periodic investments.  This process reduces the risk of market timing by smoothing out the cost basis of the investment over multiple purchases.  Where the strategy gets criticism is due to the cash drag on the money yet to be invested.  Many argue that you are better off simply investing the lump sum sooner rather than over time.  The stock market has a rich history of positive performance and growing probability of success with time invested.  Put simply, time in the market is more important than timing the market.  While I would primarily concur with that analysis, I think it’s a bit short sighted. 

“The investor’s chief problem -and even his worst enemy – is likely to be himself”.   

-Benjamin Graham, The Intelligent Investor 

Graham put it well and this quote gets to the heart of dollar-cost averaging as a behavioral finance tool.  The worst thing investors can do is try to time the market with the entire lump sum, which is the third option that gets little attention.  This can turn into a vicious cycle where they continually watch the market climb higher while remaining on the sidelines.  This is relevant because many times people who are considering dollar-cost averaging vs. a lump sum are weary about the timing of their investment.  It has been my experience that dollar-cost averaging provides a disciplined framework to get invested. 

Dollar-Cost Averaging for Saving 

We talked about the lump sum comparison, but in practice, these situations are the minority. Most investors are faced with the opportunity to use dollar-cost averaging with their on-going savings strategy.  This is the application of designating a set amount of money to be invested in regular intervals.  Instead of waiting until you have a big pot of money to invest this allows investors to take advantage of time in the market.  This strategy is also beneficial from a budgeting perspective.  It forces individuals to stay on top of savings and allows for better planning of future cash flow.   

Whether you are new to investing with a lump sum or looking for a disciplined saving strategy, dollar-cost averaging can be a powerful tool to help build sustainable wealth.