Pitfalls of Dollar-Cost Averaging
In the previous article, we learned about what dollar-cost averaging is. We also learned about some of the benefits that this strategy has to offer. Many successful retail investors have hailed this strategy to be the most important factor that has contributed to their success. However, that does not mean that the dollar cost averaging is without its flaws. In this article, we will have a closer look at some of the criticisms that have been leveled against dollar-cost averaging in all these years.
- Implicit Assumption: The dollar-cost averaging philosophy works on an implicit assumption that the market is overvalued as of now. Hence over a period of time, the market will continue to go down, and then after it hits rock bottom, it will bounce back once again. This is the reason that the investments are staggered. The idea is to have more money to invest if the market goes down, and then when it comes back up, the cost would be averaged. In a lot of cases, this does not happen. There are several instances where the market has kept growing for a five year period without any downturns. In such a case, the investor would have been better off had they simply invested the money upfront in the beginning. Dollar-cost averaging provides sub-optimal returns during periods of high growth.
- Complicated: Another problem with dollar-cost averaging is that the system to evaluate the investment performance is very complicated. An average investor can calculate their returns when they invest in a lump sum. This is because such calculations require a basic understanding of arithmetic and can be easily done. On the other hand, when staggered investments are made over long periods of time, the calculation of returns becomes difficult. This is the reason why many critics argue that investors are not able to find the true return being provided by their investments since they get lost in the effect of compounding. Often time, the rate at which the investment is compounding may not be very attractive.
- Lower Returns: Critics of dollar-cost averaging argue that the people who invest using dollar-cost averaging earn lower returns. This is largely because these investors start believing that the manner in which they invest is more important than the companies which they choose for making investments. This is certainly not true. Hence, if dollar-cost averaging is used to invest in companies that do not have robust business models, the end result is suboptimal. However, it is not necessary for people who invest using a dollar-cost averaging to pick up bad stocks. This is just an observation that has been made in many cases.
- Higher Transaction Costs: Dollar-cost averaging is a strategy in which people are buying small quantities of stock every month. Also, investors are generally advised to use the services of a mutual fund in order to do so. The end result is that the transaction costs are higher since investors have to pay for brokerage, annual maintenance fees, and other transaction costs that are charged by mutual funds. Over the long term, these transaction costs could put a severe dent in the earnings of the investor.
- Shorter Time in Market: Another problem with dollar-cost averaging is that investors who use this approach keep their money for shorter times in the market. This is because if they have a lump sum of $100, they will not invest it right away. Instead, they will break it up into smaller parts. Hence, for a large portion of time, a lot of the money will stay in the bank account, waiting to be invested. Many critics feel that this lowers the overall return offered by dollar-cost averaging. The reality is that the return made is the function of time spent on money in the market. In the case of dollar-cost averaging, the weighted average time for which the money is invested is less.
- Asset Allocation: According to financial experts, an investor can get the optimal return on their investment if they choose an asset allocation based on their needs. People who can afford to lose more money should choose a more aggressive asset allocation strategy as compared to people who cannot afford to lose money. However, regardless of which asset allocation strategy is chosen, it becomes difficult to follow because of the dollar-cost averaging method. The dollar-cost averaging method encourages people to hold a significant amount of their investments in cash, which makes it difficult to adhere to the strategy. Over the long run, the inability to adhere to the strategy causes losses.
The bottom line is that dollar-cost averaging can cause investment performance to be suboptimal in certain cases. However, suboptimal here means that the return on investment may be a few percentage points less. However, the chances of losing the principal due to wrongly timing the market are reduced significantly when the dollar-cost averaging method is used.
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