Dollar Cost Averaging Woes
The general concept of dollar cost averaging (DCA), a systematic and gradual method investing, seems like a sound approach. The standard advice is that this is the way to commit your money. Well, not always.
Specifics vary, but DCA involves investing a fixed dollar amount at regular intervals over a specified period, as opposed to lump-sum investing (LSI) – that is, investing all at once.
A popular notion: DCA somehow benefits your investing by allowing you to buy more shares when market prices dip and fewer shares when prices soar.
Maybe, though these titles of academic papers on DCA seem pretty clear about the answer:
Nobody wants to commit too much money in case the market plunges. Intuition sometimes also tells you that when a market that goes up over time and offers a premium for buying stocks and bonds, the best chance for success lies with LSI. In the paper “Dollar Cost Averaging Just Means Taking Risk Later,” a Vanguard analyst concludes:
“An LSI approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments … the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible.”
Not to say LSI outperforms over all periods: DCA did better in market downturns. If you’re a very nervous investor who wants to dip in a toe rather than dive into the market headfirst, DCA may work well – especially when coupled with luck and timing.
“ … 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 DCA may be of use,” the Vanguard paper continues.
“Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stocks and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.”
If you invest a portion of each paycheck in a savings or retirement account, you already do your own form of DCA, as much of the popular writing about DCA urges you to do. That is notably different from your holding back available cash from going into a target asset allocation, a portfolio strategy of specifying your allocations toward various classes of assets.
Know that transaction costs with DCA can run steep: In transaction-based accounts, the more DCA activity the higher the cost to the investor.
LSI into an asset allocation appropriately reflects the objectives and risk tolerance for most investors. One potential use for DCA: If you receive a large amount of money at once, such as from selling a business, and never invested so large an amount before. If new to big investing you might panic at even a brief market downturn that costs you a lot.
DCA helps the transition and supports discipline for your ongoing investing.
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Martha Post, CFA, is chief investment officer and head of the Hewins Investment Committee at Hewins Financial Advisors, LLC, in San Mateo, Calif.
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