Updated: Mar 27, 2022
Building Generational Wealth via DOLLAR COST AVERAGING (DCA)
African American Descendants of Slaves (ADOS) and other people of color often hear stories at work, cookouts, cocktail parties, and tailgating events about how a relative or friend made a nice sum by investing in stocks.
Contrary to lump sum investment strategies used by wealthy investors, the average investor invests monthly over their work life. If you are a beginning investor or an investor with a long-term investment horizon, you may want to consider Dollar Cost Averaging (DCA). Dollar-cost averaging occurs when an investor allocates a set amount of money at regular intervals.
Chances are if you are participating in any of the following retirement plans you may be deploying DCA already.
401(k): This is the most common defined contribution plan. 401(k)s are funded by pre-tax employee contributions as well as matching or non-matching contributions from employers.
Roth 401(k): This version of the 401(k) lets employees contribute after-tax funds. Companies cannot contribute matching funds to Roth accounts, so employer contributions are placed in a complementary 401(k) if you opt for a Roth 401(k).
403(b) and 457(b) plans: These plans are offered by government agencies, public educational institutions, certain nonprofits, and religious organizations. Both 403(b) and 457 plans may offer Roth accounts.
SEP IRA: Designed for self-employed individuals and small businesses, SEPs require employers to make the same percentage-of-salary contribution to each participating employee’s plan. Employees do not make contributions, and Roth options are not available.
SIMPLE IRA: Designed for companies with 100 or fewer employees, SIMPLE IRAs may provide employer matching or require employer contributions, regardless of employee participation. Employees are always able to contribute to a SIMPLE IRA. Roth accounts are not available.
Thrift Savings Plan (TSP): Available for employees of the federal government and members of the armed services, a TSP allows both employers and employees to contribute. Roth accounts are available, but investment options are generally more limited than other defined contribution plans.
Profit-sharing plans: These plans are funded only with employer contributions, typically from a business’s earnings. Each employee generally receives a percentage of earnings, although contribution amounts may change based on a business’s overall profitability.
Money purchase plans: Commonly known as 401(a) plans. Money purchase plans function like profit-sharing plans, except that employers make fixed annual contributions to every employee’s account, no matter what earnings and profitability look like in a given year. Employees may be required to contribute a percentage of their salary. You may participate in a 401(a) plan and a 457 deferred compensation plan.
Employee stock ownership plans (ESOPs): These plans are funded with shares of an employer’s stock.
Dollar-Cost Averaging is not limited to retirement plans: Chances are if you are participating in college savings plans you may be deploying DCA. This strategy could also apply to a regular Mutual Fund or Exchange Traded Fund. (ETF)
Now don’t get me wrong…the DCA strategy does not guarantee all good returns on your investment. But if you want to reduce the risk of loss to your investment and you want to control your emotions…then dollar-cost averaging could be a viable option for you.
In the white paper. ‘John Doe's Old-Age Provision: Dollar Cost Averaging and Time Diversiﬁcation,’ Dirk Ulbricht pointed out that many investment advisers suggest that the risks associated with investing can be diversiﬁed away using timing and time. The white paper suggests diversifying investments over diﬀerent market periods and extending the length of the investment horizon. This is code for time diversiﬁcation. From time to time markets become bearish…securities prices fall. Widespread pessimism causes the negative sentiment to be self-sustaining. Then, the markets invoke a healing process and recover, becoming bullish…if the horizon is long enough, stock investments will always considerably outperform riskless alternatives.
Morningstar Investment Research gives a straightforward explanation of how Dollar-Cost Averaging works. “It is a way to buy more of an investment when it’s cheaper and less when it’s expensive. To dollar-cost average, you simply invest the same amount of money every week, month, or paycheck so that, as an investment’s price falls, you automatically buy more shares .”
DCA or Lump Sum Investing?
As an investor, you might ask the question: Is DCA better than investing a Lump Sum?
Vanguard Center for Retirement Research revealed in a recent survey that a Lump Sum Investment (LSI) approach would outperform a DCA approach the majority of the time. At the same time, this study suggests that if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then Dollar Cost Averaging (DCA) should be deployed.
The study cites an example of an employee transferring a portion of each paycheck into a retirement account. Relatively small amounts over time, make DCA a prudent way to invest.
As the JP Morgan chart above clearly shows…the key strategy is to accumulate as many shares as possible throughout the accumulation period of the investment. This result would be assets of greater value that could be deployed to meet Financial Goals.
NOTES ON RISK: Generally, investments are subject to risk. Past performance is no guarantee of future returns. We have purposely omitted reference to specific investment performance and returns. Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. There is no guarantee that any particular asset allocation or a mix of funds will meet your investment objectives or provide you with a given level of income.
Resources and References
Forbes.com, Kate Ashford and Benjamin Curry ‘What Is A Defined Contribution Plan?’ Dec 16, 2021
John Doe's Old-Age Provision: Dollar Cost Averaging and Time Diversiﬁcation | The German Institute for Economic Research or more commonly DIW Berlin | diw.de/en |
Morningstar Investment Research: What is DCA?| http://www.morningstar.com/InvGlossary/dollar-cost-averaging.aspx
Vanguard Center for Retirement Research |Dollar-Cost Averaging Just Means Taking Risk Later| https://personal.vanguard.com/pdf/s315.pdfrd.com/pdf/s315.pdf