Have you ever been in a situation where you found yourself with a large amount of cash to invest? Perhaps it was from an inheritance, or from a bonus at work.  Or maybe you actually won a lottery!  In any case, how did you go about investing the money?  Did you identify some number of stocks or mutual funds and buy them all at once?  Or were you fearful that the moment you bought, there would be a market correction or recession and you would immediately lose money on your investment?  I’ve found this latter concern to be pervasive among quite a few investors, especially those who have kept their savings in bank CDs and other low risk/low yield investments.  If you are new to the world of investing, or find yourself with a chunk of cash to invest, one approach that can help you avoid the risk of investing when you believe prices are currently high is called dollar cost averaging (DCA).

The way DCA works is quite simple. Instead of investing all the money at once, you spread out the purchases over some period of time.  For example, you could choose to invest 25% of the money each quarter, or 1/6^th of the available cash each month over a six month period.  Your approach should reflect your short term expectations about market performance.  For example, suppose you have $100,000 to invest and have decided to invest it all into an S&P 500 index fund.  Suppose also that you want to make your purchases quarterly (25% each quarter) starting the beginning of January.  If this were 2011, DCA would have served you well.  The price per share of one such fund on January 2 was $127, rose to $133 at the beginning of April, to $134 in July, and then dropped to $109 in October.  If you had used 25% of your funds to purchase the fund each quarter, you would have paid an average of $125, slightly less than the $127 you would have paid had you invested all the money in January.

When is the best time to utilize DCA? When there’s a high risk of a market decline in the short term.  Taking the example above and moving it to 2008, you would have paid only $129 on average for the fund via DCA, as compared to $144 if you had made the complete purchase in January of that year.  Keep in mind, however, that if you are an investor, you expect the prices of your invested assets to increase over time.  Otherwise you wouldn’t have invested in those assets in the first place.  So from a longer-term perspective, DCA isn’t really the best strategy to follow.  You might as well buy sooner rather than later.  Take 2013, for example, when stock prices pretty much kept increasing throughout the year.  If you had purchased that index fund at the beginning of January, you’d have paid $146 per share.  If you had utilized DCA instead, you would have paid on average $158 per share.

I’ve found DCA to be most valuable in helping conservative investors overcome their fear of buying into more volatile asset class such as stocks with which they’ve historically not been comfortable. The alternative – avoiding the higher return asset classes and limiting one’s investments to conservative assets with low returns – can actually put a retirement at greater risk.  Probably the most common and effective application of DCA is during the phase in your life when you are saving money and executing a savings allocation plan to periodically invest it.  You would be applying the principle of DCA without probably even thinking about it.

Although in the long term DCA will probably not have any material effect on your portfolio, it can help in the short term, especially during turbulent times. There are few investors who have the stamina and fortitude to focus on their long term investment future and ignore what’s happening right now.  If you’re the type to constantly review your portfolio’s performance, DCA can help soften the blow if prices should drop.