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The fact of the matter is: Most of us dollar-cost average when we invest because we have to. We get paid biweekly or monthly, and we invest our savings as soon as we receive it. We don’t have gigantic piles of money sitting around that we must choose to invest in a lump or over time.
But because dollar-cost averaging is personal finance 101, you’re going to find arguments as to why it’s the “best” way to invest anyway all over the place.
The refrain goes something like this: Let’s say that rather than put all your money into a mutual fund at once, you invest a set amount, say $1,000 per month, over time. When the fund is at $100 per share, you’ll buy 10 shares. When it’s at $150, you’ll only buy 7 or so shares. That way, you force yourself to buy more shares when they’re cheap and fewer when they’re expensive! You’ll see that argument at lots of reputable sites.
The problem with that explanation is that it suggests if you did have the choice between investing over time or all at once, you should invest over time. That doesn’t make sense, and here’s why.
1. Dollar-cost averaging works in reverse when you retire anyway.
Just as you might put $1,000 per month into stocks when you’re in the wealth accumulation stage of your life, you’re going to withdraw, say, $10,000 per month from your portfolio when you retire. And yes, that means you’ll be selling more shares when they’re cheap and fewer when they’re expensive — just the opposite of the supposed benefits dollar-cost averaging gave you when you started!
2. When you rebalance your assets as you age, it’s unrealistic to keep the strategy up.
Most of us invest a lot in stocks when we’re young and less in stocks (and more in bonds) as we age. Conventional wisdom holds that you should have, say, 90% in stocks and 10% in bonds when you’re in your 20s, but closer to 40% in stocks near retirement. But how do you get from one allocation to the other?
Dollar-cost averaging would seemingly dictate that you should slowly re-balance your portfolio as you age every month. In other words, when you hit, say, age 30, you’d sell a bit of your stock portfolio and buy a little bit of bonds each month as you got older. Aside from falling into the trap described in point one, how many of us could keep that up? And if we could, the transactional costs associated with the process, such as commissions from trading ETFs, would eat into our savings.
3. If you do have a lump-sum to invest, and choose to dollar-cost average, you’re throwing your asset allocation off, big time.
Pretend you’re in your 30s, have $100,000 saved so far in a 80/20 stock/bond mix, and come into a $100,000 inheritance. Hearing of the merits of the dollar-cost average approach, you choose to trickle the money into the stock market over time.
Well guess what? On day one, your asset allocation would be 40% stocks, 10% bonds, and 50% cash. Not exactly the aggressive asset allocation you intended, right? Just because you mentally put the $100,000 inheritance into a pile of money separate from your retirement savings doesn’t make it actually so.
And if you believe the stock market generally rises over long periods of time. The short-term volatility you’re trying to smooth out doesn’t matter anyway. The best time to invest will always be ASAP.
Something dollar-cost averaging is good at
At the end of the day, the completely rational individual would choose to make a lump-sum investment instead of to dollar-cost average. But exactly zero of us are completely rational. So there’s one big reason I can see someone choosing the DCA route, despite the arguments against.
In two words: “Loss aversion.” Humans fear losses more than they love gains. This tendency is well-documented by economists. So if you invested all $100,000 in a lump sum and the market dropped 5% the next day, you’d leave with an emotional scar. But alternately, if you began a DCA program and the market rocketed 5% the next day, you wouldn’t be nearly as sad.
That’s not rational — but it is the way we think. If you can’t get over that hump, you might decide that the cost of dollar-cost averaging is worth your emotional well-being. Just don’t pretend it’s making you money.
Updated June 16, 2010 and originally published March 29, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.
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{ 8 comments… read them below or add one }
Dollar cost averaging is just a marketing scheme by the mutual fund/investment companies. They know people don’t have lump sums to invest so it’s designed to make people feel good about investing consistently. Transaction costs alone could be a big argument for not using dollar cost averaging with any type of lump sum or rebalancing.
Some use the excuse that the only way average americans can invest is weekly, 401k deductions, dollar cost averaging, etc…. but if those same folks transferred a certain amount weekly into their savings account, then they would become ‘Real’ investors who have ‘lump sums’ to invest in WHATEVER THEY PLEASE when they want, rather than the ‘average’ run of the mill expensive 401k ‘mutual fund’ choice(s). It’s really a matter of mindset, not money. If you really want to invest beyond the average person’s choices, then you have act differently than the average person.
Love the avatar. I always invest as much money as possible as soon as I can. It’s best to train yourself not to care if you lose money (yes, it can be done) than to always second-guess your timing decisions.
I agree with your first statement: I dollar-cost average because I have to. Unfortunately, I don’t have lump sums to put into a retirement savings vehicle. I do have payroll deductions that go towards my 401(k).
In addition to what you mentioned, I see 2 additional benefits to DCA.
1. If you’re in a 401(k) and your company offers a match, it only makes sense to contribute per pay period. They are likely matching what you put in per pay period and not per lump sum.
Corollary to 1: I guess you could contribute *most* of the IRS limit near the beginning of the year and still get company matching, if you want to do that type of thing.
2. It’s easy to budget. I can more reasonably set aside $500 a month than I can $6000 all at once.
Arguments 1 and 2 from this post make no sense from a logic standpoint.
“1. Dollar-cost averaging works in reverse when you retire anyway.”
How does that argument make dollar-cost averaging when you invest a bad strategy?! It is a good point that you shouldn’t take money out in fixed dollar amounts when you retire, but dollar-cost-averaging does smooth out the variations in the market when you buy. Investing in one lump sum is no different than trying to time the market at once. Dollar-cost averaging softens the impact of timing. It works very well when we have slumps or market crashes even though the long term market trend might be positive. Over the long haul, it shouldn’t matter so much but it could make an instant 3-5% difference, If somebody had invested $100K in August(?), 2008 before the market crash, it could have made a huge difference!
“2. When you rebalance your assets as you age, it’s unrealistic to keep the strategy up.”
It’s not unrealistic. People do it. It’s not that hard, (like balancing a checkbook), and if it’s done within a 401K where you have enough stock funds to transfer out of, there are no fees or penalties. Presumably, a target retirement fund can do it for you, but some of those fund managers screwed things up by being too aggressive.
I’m disappointed that this article was posted; I feel it is flawed. I’m also surprised that other commenters jumped on the bandwagon. If anything, I would say that the investment companies want you to invest in a lump sum, (if you could). It’s instant cash for them and it saves on transaction costs for them. What these companies don’t want you to do is conduct many transactions or buy a wide assortment of funds without too much money in each. That costs them more.
I’d also have to agree with UH2L’s comment above in that rebalancing as you age is not an unrealistic strategy as you age. Just as with a 401k, I believe that there are also no costs to transfer funds out of stocks and into bonds within an IRA.
And regarding point 3, if I had a lump sum to invest, I would not dollar cost average in this case. I’d just put $80k in stocks, and $20k in bonds to keep the 80/20 mix. Then I’d rebalance again as necessary.
I like this article! Gave me something new to think about!
Great guest post. I hope you do a few more in the future
This analysis is incredibly misleading.
A truly rational individual, who understands the market, would never do what you are advocating. Making a relatively large lump-sum investment is the equivalent going “all in” in a game of Texas Hold ‘em before you even look at your cards.
It is never a good idea to go all in with a relatively large sum. The larger the sum is relative to what you already have in the market, the worse this idea becomes. This is because there is no way to time the market – there is no way to know if you are going all in with the bulls or the bears. By going all in you run the risk of going in during a bear market.
Over the years there have been 25 bear markets, periods of time when the value of the market is declining – and 25 bull markets, periods of time when the value of the market is rising. The average bear market lasted 18 months and generated a 35% decline. The average bull market lasted 35 months and generated a 115% gain.
If you had gone all in at the height of the market immediately prior to the crash of 1929, it would have taken you 25 years to recover your losses. In the 16 years between 1966 and 1982, the market was either flat or negative. If you bought an S&P 500 index fund in 2000 – a fund that invests in 500 large companies – you are still in the hole today.
And here’s the kicker – there is no way to know ahead of time if the market is in a bear period or a bull period until after it is over. If you go all in during a bear market you run the risk of losing 1/3 of the value of your lump sum. It may take years to recover your losses.
So what is a prudent investor to do?
Dollar cost average. Over 2 years. This minimizes the risk of entering the market during a declining market.
Dollar cost averaging does work in reverse during retirement. But thinking about how something works in the future has nothing at all to do with decisions made about it today. If I am planning a trip I plug my destination into my GPS. What I do when I get to my destination is completely unrelated to how I have chosen to get there.
I agree it is a good idea to re-balance your portfolio as you age. But asset allocation is also independent of the principle of dollar cost averaging. Connecting the 2 is like saying I should change my oil before I rotate my tires. They both relate to how I maintain my car, but each decision is unrelated to the other. Each decision is an independent action based on completely different criteria.
An intelligent and prudent investor determines asset allocation first, and then decides when and how much to invest in each asset class. As you set aside small amounts of money to invest over time, you re-balance your portfolio by putting the money into the vehicle that needs the heavier weighting.
The biggest reason to choose dollar cost averaging is not loss aversion, but risk management. Dollar cost averaging minimizes the risk of losing 1/3 of the value of your portfolio and waiting years – or even decades – to recover your losses.
If you invest a lump sum, be prepared to take your lumps.