[Editor's Note: This post originally ran as one of my regular columns at MDMag.com and teaches what dollar-cost averaging is and isn't and why there are better ways to reduce risk.]
Financial pundits often tout dollar-cost averaging (DCA) as a method to manage risk in the markets. However, they don’t mention that the risk this technique is managing is the investor’s own bad behavior. DCA does lower your risk, but just like other methods of lowering risk, it also lowers your expected returns.
What is Dollar-Cost Averaging?
Dollar-Cost Averaging is Not Regular Pay Check Deposits
Many investors mistakenly think they are DCA when they have money taken out of their paycheck each month and deposited into a mutual fund in their 401(k). However, this is called periodic investing and is the manner in which most investors gradually make investments throughout their careers. This is not DCA because the investor has no choice other than to invest this way. He can’t invest all his money up front because he hasn’t yet made most of the money he will invest.
Dollar-Cost Averaging is Spreading Out a Lump Sum Investment
DCA is an alternative to investing a lump sum all at once. Consider an investor who inherits $1 million or some other sum that is large in proportion to the remainder of his portfolio. She has a choice. She can invest the money all at once (lump sum) or she can invest it a little at a time, say $100,000 a month for 10 months (DCA). A proponent of DCA would demonstrate the following:
If a lump sum investor used $1 million to buy an investment at $10 per share, she would have 100,000 shares of that investment. A DCA investor might make investments over the next 10 months as follows:
The DCA investor ends up with an extra 4,449 shares because she bought many of her shares at less than $10. Furthermore, DCA will help an investor to stay the course with her investing plan and minimize possible regret if the investment goes down in value shortly after buying it. DCA also helps the investor avoid “analysis paralysis” where an investor does nothing because she cannot decide what to do.
Problems With Dollar-Cost Averaging
1. The market generally goes up
Obviously, when the price of an investment is trending down or see-sawing, buying shares later instead of now is going to work out well. But there is no way to know what the market is going to do in advance, and historical data demonstrates that a typical investment goes up in value over time. If you didn’t expect an investment to go up in value, why would you buy it anyway?
If you look at a gradually rising market (as we’ve had for the last four-and-a-half years), the results come out very differently.
You still end up with the same 100,000 shares with the lump sum investment, but you only get 85,709 with DCA. If you look at the S&P 500 stock index from 1926 to 2011 (86 years), you’ll see that the index (counting dividends) ended higher at the end of the year than at the beginning in 62 of those years, or about 72% of the time. If the future resembles the past, waiting to buy means you’ll be buying at higher prices.
2. You miss out on the dividends for those shares that weren’t invested originally
Consider an investment that puts out a quarterly dividend of 0.5%. If you own 100,000 shares, that’s $500. If you were DCA and thus only owned 30,000 shares, that’s only $150. Even if the share price remained exactly the same all year, the lump sum investor would come out about $600 ahead. Sure, he may have had the uninvested money in his bank account or money market fund for those 10 months, but given current rates, that wouldn’t have paid anywhere near $600 in interest.
3. It's a Hassle and Opens the Door to Behavioral Mistakes
Proponents argue that a DCA investor can minimize regret if his initial investment goes down in value because the next month he gets to buy even more shares at a lower price. I would argue that not only does it cost more money to make many separate transactions, but it also gives the investor many more opportunities to doubt himself and make a behavioral mistake.
4. Lower Expected Returns
DCA does help control risk. Your money is exposed to market risks for less time. If there were a major market correction in month three of your DCA plan you would only have a third of your money exposed to it and would thus lose less money. However, as a general rule, the market pays you to take risk. When you take less risk, you have lower expected returns.
Unfortunately, at the end of the DCA period, all of your money is exposed to those same market forces. If you were uncomfortable exposing your money to those risks earlier, why would you be more comfortable now? It is simply a behavioral bias, with no logic behind it. Investing with your emotions instead of your mind is a recipe for disaster.
A Better Way to Control Risk Than Dollar-Cost Averaging
If you are uncomfortable with a high percentage of your portfolio invested in risky assets, the answer isn’t to invest a high percentage of your portfolio into risky assets over time. The answer is to place a smaller percentage of your money into risky assets.
Instead of investing in a portfolio of 80% risky assets (such as stocks) and 20% less risky assets (such as bonds) over 10 months, perhaps you should lump sum into a portfolio of 50% stocks and 50% bonds right now, and then maintain and rebalance that portfolio over time. Developing a written investment plan and then following that plan is the way successful investors reach their goals. You should only change that plan in response to changes in your life causing your need, ability, or desire to take risk to change, not in response to market or news events.
DCA is a method of managing your own emotions to avoid regret, inaction, and reactive selling of investments at market lows. However, most investors, when given a choice between a smaller chance of avoiding regret and a larger chance of having more money in the end, will choose to manage their own emotions and invest their lump sum all at once as their investment plan decrees.
What do you think? Do you routinely dollar-cost-average in lump sums? Why or why not? Comment below!