Dollar-cost averaging, or DCA, refers to the practice of investing or divesting as a series of instalments over time rather than as a lump sum. DCA is intended as a risk management tool; the idea is that it 'averages out' the purchase or sell price of an investment, thereby reducing variability in the return – in particular, protecting against a poor outcome due to sudden, significant movements in prices after purchase or before sale of an investment. But the question is, does it deliver better outcomes than lump sum investment? James Claridge, a Senior Product Manager at OMG decided to run the numbers and test the theory.

We looked at a variety of DCA scenarios for some hypothetical investments into diversified Australian equities, as represented by the ASX200, and some specific stocks, namely Westpac Banking Corporation (WBC.ASX), Commonwealth Bank (CBA.ASX) and Zip Co (Z1P.ASX). Essentially, we turned back time to see what would have happened if we’d made investments into these as a lump sum vs using DCA. (We looked at the performance based on total return; including dividends and excluding transaction fees, which may be higher for DCA).

There are quite a few factors that impact dollar cost averaging including investment time horizon, DCA period and frequency, risk tolerance and transaction fees.

So first up, we looked at a $100k investment in an ASX200 ETF, across 2, 5 & 10 year investment periods with different DCA frequencies and periods and different risk/confidence levels (see percentiles of outcomes below).

Chart 1 below shows the impact of equal monthly instalments across 24, 12 or 6 months OR a lump sum investment up front (‘none’). The percentiles show the level of risk/confidence. For example, “90%” indicates that 90% of the time the result will be the value shown or less – you can think of this as the top 10% of returns. Similarly, “10%” indicates that 10% of the time the result will be the value shown or less – you can think of this as the bottom 10% of outcomes.

^{Chart 1: DCA at various frequencies over two years with ASX200. }

So, we can see that at the 90% percentile (top 10% of outcomes) the outcome gets better as the DCA period gets smaller and is best without any DCA at all (lump sum). In fact, this appears to be the case for all but the very bottom 10% of outcomes where DCA does appear to provide a very small improvement, which is consistent with that we might expect – after all, DCA is intended as a risk management strategy.

Chart 2 below shows a similar analysis over a 10-year investment period.

^{Chart 2: DCA vs lump sum investment at various frequencies over 10 years with ASX200. }

Again, this suggests that DCA does not provide significant risk management benefit, even at the bottom 10% of outcomes. It also shows that shorter DCA periods generally produce better outcomes.

Chart 3 below shows the impact of changing the frequency of DCA; outcomes at the 10% percentile (bottom 10% of outcomes) for a 5-year investment period. For example, the green bar shown in the group of bars on the left shows the outcomes from investing weekly over the first six months of the investment period.

^{Chart 3. DCA vs lump sum investment over five years at various investment frequencies with ASX200.}

From this we can see that DCA frequency does not have a big impact on outcomes. If anything, fewer investments further apart – i.e. lower frequency – produces marginally better outcomes.

Chart 4 below shows the comparison of historical outcomes between DCA (monthly over 6 months) and no DCA (upfront investment) for 5-year investment periods. The dates on the horizontal axis refer to the start date of the 5-year investment period.

^{Chart 4. DCA vs lump sum investment over five years with ASX200.}

There’s not a lot in it. You can see that while DCA does remove some of the volatility (red line is a little smoother than blue line) - the effect is small. Mostly, DCA produces lower outcomes than upfront investment but there are patches where it produces better outcomes, for example during the GFC.

Individual stocks tend to be more volatile than the ASX200, so is DCA more effective for single stocks? The following charts show outcomes for Westpac (WBC.ASX), Commonwealth Bank (CBA.ASX) and Zip Co (Z1P.ASX).

Chart 5 shows the same analysis as Chart 2 above, this time using WBC as the investment. While the absolute numbers are different, the pattern is the same.

^{Chart 5. WBC 10 year investment}

Chart 6 also shows outcomes for WBC, this time based on a 5-year investment period and DCA over 6 months. The chart shows the outcome at each percentile, where 0% is the worst outcome and 100% is the best outcome.

^{Chart 6. WBC with and without DCA}

While not easily visible, Chart 6 does show that DCA (red line) produces slightly better outcomes at the bottom end, but at the cost of much lower outcomes at the top end.

The below charts show similar analyses for CBA and Z1P.

^{Chart 7. CBA with and without DCA}

^{Chart 8. Z1P with and without DCA}

These charts tell a similar story (slightly better outcomes at the bottom end of returns and worse at the top). Chart 8 also shows how extreme outcomes can be; in the case of Z1P there was at least one 5-year period where an investment of $100,000 would have become $8M! But also, at least one 5-year period where $100,000 would have turned into only $5,000. Even in the case of the worst outcome, DCA provided only a little protection; the worst outcome with DCA was $5,100, without DCA it was $4,600.

There is no doubt that DCA produces better outcomes than upfront (lump sum) investments some of the time and provides some protection against the bottom end of returns, though it would appear this is not highly significant. Generally, the analysis suggests that:

- DCA is more effective for more volatile stocks and portfolios
- DCA has relatively greater impact for shorter investment time horizons
- Shorter DCA periods and lower DCA frequencies produce better outcomes

However, it appears that while DCA provides a little downside protection, it comes at the cost of reduced upside.

Some other key points to note:

- For small investment amounts, DCA may result in higher transaction fees which may offset any benefit of DCA
- On the sell-side it could be better to leave an investment in place for as long as possible (sell as a lump sum at the end) rather than starting to sell-down earlier in instalments (but depends on your cash needs!). Generally, “time in the market” wins.

So what’s better? Smaller investments each time you receive your salary or accumulating your savings and investing a larger lump sum later? While the analysis is not shown here, historical data suggests that – excluding the effect of transaction fees – it is better to invest immediately savings are available (smaller amounts more often). Time in the market is what matters most.

However, it's worth noting that transaction fees may become significant if the investment amounts are small, so accumulation into fewer investments of larger amounts may produce better outcomes.

Want to learn more about DCA? Check out our Trading Edge webinar recording with James Claridge, our resident expert on longer term investment strategies.

*Hold on a sec! You should consider whether any advice here is right for you. We don’t accept any responsibility for the accuracy of any information, opinions, or predictions we’ve provided, and we certainly haven’t taken your personal financial situation into account. Just a heads-up – you should seek professional investment advice before taking any action relating to above information.*