What You Need to Know About Dollar-Cost Averaging
Imagine this scenario: you have $12,000 to invest in the stock market. Should you put it all in now or do you spread out your investments by putting in $1,000 a month for 12 months? This is the dilemma behind the dollar-cost averaging debate.
Dollar-cost averaging defined
Dollar-cost averaging (DCA) is a strategy for investing a large sum of money gradually in an attempt to control risk. Typically, investors using a DCA approach will invest equal amounts of money into a stock or mutual fund at fixed intervals, regardless of how the market is performing. The alternative to this is lump sum investing (LSI) where you invest all the money into your portfolio at once.
Some people consider regular contributions to their 401(k) to be an example of DCA. However, DCA in those situations is more a matter of practicality; you invest money as it becomes available to you. For this article, we will explore the concept of using DCA when you already have a lump sum ready to invest. Lump sums can come from several different sources — a pension payout, inheritance, the sale of property or a business, or even winning the lottery.
The Benefits of DCA
The idea of DCA certainly sounds appealing to many investors. You may fear that the markets will plummet after you invest a lump sum, causing a large loss in your investment portfolio. Or, you may be trying to diversify the price paid for a stock or mutual fund. Since the markets move up and down all the time, you would buy more shares when the price is low and fewer shares when the price is high. By doing so, the average cost per share theoretically is lowered, and the risk associated with making a lump-sum purchase when prices are high is eliminated.
According to finance professor Ken French, there is also a strong psychological benefit to DCA. He believes that people are more likely to regret buying stock that goes down afterward (an error of commission) as opposed to not buying stock that goes up (an error of omission). In other words, people turn to DCA because it makes them feel better. Irrational or not, the potential for regret is reduced by the automatic and spread out nature of this strategy.
The Downside of DCA
The main downside of DCA is that there is an opportunity cost to be paid for holding money in cash while it waits to be invested in the market. If the market goes up while you're dollar-cost averaging into it, you've lost out on any gains you would have had by investing the entire amount right away. Also, even if the markets do go down in the short term, as long as you are invested, you could still be earning dividends and interest to either reinvest or withdraw for income.
In the 2012 Vanguard study, “Dollar-cost averaging just means taking risk later,” the authors looked at historical monthly returns for $1 million invested as a lump sum and through dollar-cost averaging over periods as short as 6 months and as long as 36 months, assuming that funds were kept in cash before being invested. They tested various stock/bond allocations ranging from an all-equities portfolio to an all-bond portfolio in the United States, United Kingdom and Australian markets.
Figure 1: Relative historical probability of outperformance for LSI versus 12-month DCA at varying allocations
Source: July 2012 Vanguard study “Dollar-cost averaging just means taking risk later.” Vanguard calculations based on benchmark data. See page 7 of Vanguard study for a list of the benchmarks used.
The result was that the lump-sum method delivered higher returns about 66% of the time compared with the 12-month dollar-cost averaging method, regardless of whether an all-equities, all-bond, or 60% equity/40% bond allocation was used (See Figure 1). The authors also note that the longer the dollar-cost averaging time frame, the greater the chance of the lump-sum method outperforming. For example, dollar-cost averaging over 36 months underperformed the lump-sum method 90% of the time for U.S. markets.
In terms of dollars, the difference can significantly impact a portfolio. The authors calculated the average ending values for a $1 million portfolio invested all at once in a mix of 60% stocks and 40% bonds turned into $2,450,264 on average, compared to $2,395,824 when dollar-cost averaged over the course of a year — a difference of more than $54,000.
One last factor to consider is investing costs, which can also be a disadvantage for the DCA method. For example, using DCA could require paying multiple brokerage fees to buy shares of a stock in several lots rather than just once, which would further diminish your returns as compared with the lump-sum method.
An Alternative Strategy
Nobody can predict what the markets will do and it is natural to feel some uneasiness during times of market volatility. However, we believe a strategy of creating a well-diversified portfolio with an optimal asset allocation based upon your goals, time horizon and risk tolerance will help ease the anxiety over investing at all times. Then, rebalance periodically to stay within your asset allocation targets. If the idea of investing your money causes you a great deal of stress, then perhaps you should consider revising your target allocation to one that is more conservative.