The Unintended Cost of Dollar-Cost Averaging
Legendary country musician Johnny Cash was known for singing poignant tales with relatable motifs spanning from America’s downtrodden to unrequited love and, conceivably, dollar-cost averaging.
In the song “One Piece at a Time,” Cash bellows the story of a man who works on a General Motors assembly line in Detroit making Cadillacs. He would forlornly “watch them beauties roll by,” knowing they were too expensive for him to ever own one. That is, until he devised a plan to smuggle out a Cadillac in single parts over several years.
Although it seemed like a good plan at first, when he started to put all the pieces together he “noticed something was definitely wrong.” The finished product was a patchwork Cadillac of disparate parts dating from 1949 to 1973, entirely unlike the car he envisioned. After all, he couldn’t control changes in consumer preferences and car designs. The unintended outcome of his plan to obtain a luxury vehicle one piece at time to avoid losing his job resembles the investment strategy of periodically investing in the market in hopes of not losing your shirt, known as dollar-cost averaging.
In financial parlance, dollar-cost averaging means investing a fixed amount at regularly scheduled intervals. For example, you buy $1,000 worth of shares in the same mutual fund each month or quarter. If you make a contribution from each paycheck to an employer-sponsored retirement account, then you are dollar-cost averaging. Investors typically resort to dollar-cost averaging when they feel markets are overvalued and are worried about buying at a market peak.
By dollar-cost averaging, if markets move in your favor, you can pay a lower average cost per share as you buy more shares when the price is low and fewer shares when the price is high. This approach can also provide a behavioral benefit; it allows you to find out just how comfortable you are with your overall investment plan during market fluctuations since only a portion of your money is invested.
Whereas entering the market one piece at a time may get you shares at a discount, it could also end up costing you in returns. The disadvantage of dollar-cost averaging is that you risk missing out on a market rally when you’re not fully invested. Those upswings can produce the bulk of your realized returns over the lifetime of your investments. According to a Vanguard study on market timing, an investor would have earned a 5% return when invested in the S&P 500 for every trading day from 1928 through 2008. Missing the 10 best trading days lowers that return to 3.6%. Further, when missing the 20 best trading days, the return is nearly halved to 2.6%.
Ultimately, no one can predict market prices. If you’re concerned about overpaying or lacking the investment discipline to stick with a plan, then it may be better not to attempt a strategy on your own. Instead, you may want to consider working with an investment adviser to construct a diversified portfolio with an asset allocation tailored to your needs and tolerance for risk. Diversification can help reduce risk and create more opportunity to capture returns across different asset classes. Meanwhile, an investment adviser can help you stay invested during turbulent market periods as well as rebalance your portfolio when necessary, which helps you continue to buy low and sell high.
Dollar-cost averaging may sound good on paper, but in practice there is the risk you end up with something, like in Cash’s hit song, you didn’t intend: a gap in returns between you and the market so big, you could drive a Cadillac through it.
Photo: Johnny Cash in the driver’s seat of the “One Piece At a Time” Cadillac with Bruce Fitzpatrick standing at the far right. Photo courtesy of Abernathyautoparts / CC BY-SA.