The Disadvantages of Dollar Cost Averaging

Dollar cost averaging is a technique commonly used in the investment world. This technique involves making purchases of a security at regular intervals instead of purchasing the securities in one large lump sum purchase. Even though many people believe that the strategy is very useful, there are definitely some disadvantages associated with it.

Transaction Costs

Perhaps the biggest disadvantage of dollar cost averaging is that it ignores transaction fees. In order for an individual to implement dollar cost averaging, they will have to make regular purchases of the security. For example, an individual who implements this strategy might decide to invest $1000 into a particular stock every month. When they do this, they will have to pay a certain amount of money to their broker in commissions. This amount of money will cut into the amount of money that is generated in profit. Over a long period, this can severely erode returns and make this strategy unprofitable.

Doesn't Really Reduce Risk

One of the primary arguments in favor of dollar cost averaging is that it reduces risk. In reality, this is nothing more than a myth. Many studies have shown that dollar cost averaging does nothing to reduce market risk overall. Behind the argument that dollar cost averaging reduces risk is an insistence that, instead of putting all of your money into a stock when it could be overpriced, you should spread out the investment over a longer period and you will be able to average out the price of the stock. The only problem with this argument is that when you use dollar cost averaging, you have to make a series of decisions instead of making only a single investment decision. When you decide to dollar cost average the purchase of a stock, you might be repeatedly investing in the wrong stock instead of doing it only once.

Rising Costs

Another problem with dollar cost averaging is that you could potentially increase the average cost of a security if it continually rises in value. For example, if you decided to invest in a company that is relatively new and shows good promise, the price of that stock could increase steadily over several years. At the beginning of the investment term, the price of the stock could be the lowest that you will ever see it. If you had a lump sum to invest, this would actually be the best time to invest it all into the stock. If you only use a portion of the lump sum to invest, you will get only a limited number of shares. Then, the next time that you want to invest, the price of the stock may have gone up again. Then you will be buying even fewer shares of the stock that time. Each time, you will be able to buy fewer shares of stock than the time before. 

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