Investing

Dollar Cost Averaging Criticism: High Transaction Costs

Dollar cost averaging is an investment strategy that seeks to minimize market timing risk by spreading the investment of a large sum of cash over a fixed period of time.  This investment strategy is not without its critics. Though hailed by many personal finance experts and bloggers as a great investing strategy, DCA has not been as widely accepted among academics. According to its detractors, there are three main problems with dollar cost averaging: it increases overall transaction costs, doesn’t meaningfully protect you from timing risks, and in most cases provides sub-optimal performance as compared to other methods of investing.

I will cover the later two objections in future posts, but for now I want to focus on understanding how dollar cost averaging increases the amount money that most investors are going to fork over to brokerage firms or financial institutions.

An example is always helpful, so lets take a look at the the hypothetical finances of Vlad the Impaler.  Having seized the fortunes of many a boyar, Vlad decides that it is time to invest in the always growing American stock market.  He has a lot of cash on hand, about $3,600 US, but the instability of his native Wallachia has left Vlad a little risk adverse.  He wants to keep his money safe, so he decides to adopt a dollar cost averaging strategy over the course of a 12 month period.

Inspired by Sam Waterston’s Jack McCoy on NBC’s Law and Order, Vlad has taken a fancy to TD Ameritrade and opened an online trading account with this discount broker.  As of this writing, TD Ameritrade offers trades at a flat rate of $9.99.  This isn’t the lowest fee out there, but I think it will help us get an understanding of what the DCA critics are talking about.

Now that we have our basic assumptions on the table ($3,600 invested over 12 months with a cost of $9.99 per transaction) let’s examine the impact of the transaction costs on Vlad’s investments:

Lump Sum Investing Dollar Cost Averaging
Month 1 $9.99 $9.99
Month 2 $0.00 $9.99
Month 3 $0.00 $9.99
Month 4 $0.00 $9.99
Month 5 $0.00 $9.99
Month 6 $0.00 $9.99
Month 7 $0.00 $9.99
Month 8 $0.00 $9.99
Month 9 $0.00 $9.99
Month 10 $0.00 $9.99
Month 11 $0.00 $9.99
Month 12 $0.00 $9.99
Total $9.99 $119.88
% of Total Invested 0.28% 3.33%

Using a dollar cost averaging approach with Vlad’s stash of cash is going to eliminate over 3% of the cash that he was seeking to keep safe using this investment strategy. Granted, if Vlad’s windfall was 10 or 100 times what we used in this hypothetical situation the impact would have been reduced to .3% and .03% respectively – but who suddenly finds themselves with $36,000 or even $360,000 laying around with nothing to do with it except invest in the always growing American stock market?

In the end, a dollar cost averaging investment strategy can substantially increase costs for investors. Unless you go with a no fee brokerage firm (like Bank Of America1 or Zecco2 ) you are going to see some portion of your hard earned money go to financial middle men. This in and of itself shouldn’t stop you from dollar cost averaging if you choose, it is just something that you definitely want to take into consideration when deciding what investment strategy works best for you and your money.

  1. Must have a balance of $25,000 on account with Bank of America to qualify []
  2. Must have a balance of $2,500 with Zecco to qualify []