For years, controversy has surrounded the conventional wisdom of dollar cost averaging into the market. A recently published white paper by Vanguard has renewed the debate among advisors as to the merits of dollar cost average investing (DCA) versus lump sum investing (LSI).
The disagreement on the benefits and drawbacks of dollar cost averaging (DCA) and Lump Sum Investing (LSI) in my opinion is more about how and when to apply each strategy. The misuse of terminology is also part of the cause of disagreement as well.
PAI, DCA, LSI, What?
Many people use the terms dollar cost averaging and periodic automatic investing (PAI) interchangeably (and incorrectly). The most common example of PAI is the automated deposit to a 401k. This type of investing is done as soon as the funds are available to you to invest – usually from an income stream.
DCA, however, is an investment technique wherein an investor currently has the funds available to invest, but chooses to ease the money into the market over a period of time, usually 6, 12, or 18 months, rather than all at once. And, finally, lump sum investing (LSI) is when someone invests as soon as the funds are available.
The Origins of DCA
This type of ‘programmed investing’ gained its popularity in the 1940s. Recovery was slow and painful after the stock market crash in 1929, with recovery lasting well into the 1930s. The 1930s were also fraught with several swift declines and remarkable volatility. This volatility on the heels of a crash and a depression took a toll on the psyche of investors. Dollar cost averaging in sideways or down markets will yield the best DCA results, which is why all the back testing at this time proved the hypothesis. The discovery of a method of investing to limit the blow of an immediate decline understandably became popular – and is still so today.
We have understood since at least the early 1980s that the practice of dollar cost averaging is mathematically a suboptimal investment strategy. Dr. Bill Jones, a math professor, compared DCA over 6-, 12-, 18-, 24- and 36-month rolling periods over 44 years, versus lump sum investing, and found that LSI outperformed all five DCA time period lengths. In addition, the recent study conducted by Vanguard revealed that LSI outperformed DCA 67% of the time using rolling 10-year periods from 1926-2011. Yet, popularity for the DCA strategy has not waned. Why?
We do not make our decisions based on one criterion alone when it comes to our money. Would you play Russian roulette regardless of the fact that the odds are in your favor 5 to 1? Of course not! That’s an extreme example but the point is we assess the upside and downside potential and try and avoid a decision that will result in regret, even if the upside outweighs the downside and the odds are in our favor.
If you are anxious about going all in at once, consider DCA for 6-12 months – but no longer. Forgoing a little return would be preferable to your possible reaction had you invested your entire pension and 401k on October 9, 2007, the peak of the market before the 50% decline by March 9, 2009. You would be much worse off.
If you have an income stream, such as your earned income or pension, set up a periodic automated investment strategy. Investing the funds as soon as they are available will yield better results.
However, if you already have a large sum to invest, you should not spread the purchases out over a significantly long period of time. Either invest all at once (LSI) or phase it in over 6-12 months. Don’t delay it for too long. Delaying the purchase for more than a year is likely to yield a lower return, especially with interest rates on cash and equivalents as low as they are today. Besides, it also gives you too much time to think about where else you could spend that money you had planned to invest.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.