Most folks invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. No one has a crystal ball and can predict which direction investments will move next in the short term. DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with larger lump sums of money sitting in safe investments like CDs or savings accounts. It also makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks.
As with any risk-reducing investment strategy, DCA has its drawbacks. If growth investments appreciate (as they’re supposed to over time), a DCA investor misses out on earning higher returns on his money awaiting investment. Studying U.S. stock market data over seven decades, finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.
However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major drop in prices. For example, from late 2007 to early 2009, global stocks shed about half of their value.
If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practice DCA over too long a period of time, you may miss a major upswing in stock prices. Use DCA over one to two years to strike a balance.
When you use DCA, establish an automatic investment plan so you’re less likely to wimp out of your strategy. Your money that awaits investment in DCA should have a suitable parking place. A money market fund that’s appropriate for your tax situation is recommended.