THIS PAST WEEK, I received an email from a reader—let’s call him Tom. He described his experience during this year’s unruly stock market. After the market dropped in February and March, he said, the stock side of his portfolio lost a lot of its value. He decided to rebalance—that is, to buy more stocks so his original asset allocation would be restored. That is just what I would have done. But the key question—always, but especially this year—is timing.
With all of the doom-and-gloom news, Tom figured the market might be in for a prolonged slump. Rather than buying stocks all at once, he set up a 52-week schedule for purchasing stocks in small increments. But after hitting bottom in late March, the market quickly turned around and has since recouped nearly all its losses. Tom’s reaction? “In retrospect,” he said, his 52-week schedule was “too slow.”
To say “in retrospect” is the same as saying “with the benefit of hindsight.” In other words, there’s no way Tom could have known that the market would bounce back so quickly. I don’t know a single person who predicted the lightning-fast recovery. No one could call Tom’s go-slow decision a mistake. Still, it did give him pause. Tom wrote to ask if there was a better approach. Below are a few thoughts on the topic.
Tom’s question fits into a broader category of question, which is: When you have a sum of money, whether it’s from a bonus, a windfall or an inheritance, or you’re shifting money from one side of your portfolio to another, should you invest all at once or incrementally? The all-at-once approach is straightforward. But let’s take a closer look at the incremental approach, the approach that Tom took.
There’s a variety of incremental approaches, the most common of which is called dollar-cost averaging (DCA). Investors often ask if there is an ideal way to structure a DCA plan. Does it make sense to invest in weekly increments, as Tom set out to do, or to opt for monthly investments instead? And what is the ideal time frame? Should a dollar-cost averaging plan span weeks, months or even years?
There’s no scientific answer to this question—because dollar-cost averaging isn’t an evidence-based strategy. It’s what I would call a behavioral strategy. What do I mean by that? If you think about it, the stock market goes up more frequently than it goes down. In 69 of the past 95 years, the U.S. stock market has delivered a positive return. That’s more than 70% of the time. If you’re planning to invest in the market strictly according to the statistics, you’re much better off investing all at once rather than incrementally. After all, the market is more likely to rise than fall in the year after you invest.
Vanguard Group has analyzed this in detail. In a 2016 report, it studied a variety of markets and time periods and confirmed that “lump sum” investing beats dollar-cost averaging about two-thirds of the time.
But as I said, dollar-cost averaging is a behavioral strategy—and it’s a powerful one. Imagine you’d received a windfall in February of this year and invested it in the stock market all at once. In less than six weeks, you would have seen 35% of your money evaporate. And like Tom, you wouldn’t have had any assurance that it would return any time soon. That, in a nutshell, is the value of dollar-cost averaging. To be sure, events like the one we saw this year are unusual. But they’re not that unusual. As you may recall, the market dropped about 20% near the end of 2018. It recovered quickly in that case, too, but other bear markets have been longer and more unpleasant.
This is why, despite the statistics, I still recommend dollar-cost averaging. But because it isn’t a principle that is based in math, the downside is that there’s no scientific way to approach it. The only thing the data say is that, if you’re going the route of dollar-cost averaging, quicker is better. The longer you draw out an investing schedule, the more likely it is to work against you.
Here are two more thoughts on how best to construct a schedule. First, since there’s no ideal strategy, you should feel free to approach your investment schedule flexibly. In general, I think monthly investments are more manageable than weekly. But again, there’s no science to it. What’s most important, in my view, is to choose a pace that’s slow enough that you’ll be able to stick with it through market declines like we saw this year. That’s especially important because declines are a gift if you’re dollar-cost averaging and you wouldn’t want to miss out. In fact, it would largely defeat the purpose to stop investing during a market downturn since you’d end up buying at higher prices.
Second, while it’s important to stick to a schedule, I also think it’s a good idea to accelerate things if the market does decline. As I said, that’s a gift if it happens, so you might increase your monthly investments if a bear market comes along. There are lots of ways to do this. The simplest would be to double your investments in months when the market is down. A more aggressive approach would be to ratchet up your investments in a way that’s inversely proportional to market declines. In contrast to traditional dollar-cost averaging, which involves fixed monthly investments, this sort of ratchet approach would result in more dollars being invested when the market goes on sale.
Bottom line: Like most things in finance, I recommend keeping it simple. There are lots of more complicated approaches out there, such as value averaging, an idea that’s interesting but so complicated that it has little appeal in the real world. And since none of these techniques is based in science, there’s no sense being too scientific about it. The “right” approach is the one that’s right for you.
Adam M. Grossman’s previous articles include Sticking With It, Think Like a Winner and Looking for an Edge. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.