Dollar Averaging

When investors talk about dollar-cost averaging, they often confuse two strategies—one widely used, the other more controversial.

Do you regularly add new savings to your investment portfolio? During our working years, many of us do that. When we get our paycheck, we slice off a few dollars and toss them into our employer’s 401(k) or 403(b). We might call this dollar-cost averaging (DCA), but it’s less a strategy we consciously adopt and more a function of how we get paid.

Every so often, however, we have the choice of whether to dollar-average into the financial markets or not. We might get a year-end bonus, the proceeds from a home sale, a lump-sum pension payout, an inheritance or some other large chunk of cash. If we’re going to invest the money, we have to decide whether to dump our lump sum into the financial markets all at once or spoon it in over time.

DCA purports to offer some mathematical magic—that, by investing the same sum every month, we can end up paying a lower average cost per share than intuition might suggest. But in truth, the strategy’s greatest virtue is emotional. DCA makes it easier to invest a large sum—because we avoid the risk of dumping a big chunk of change into stocks and then immediately seeing it devoured by a market crash, with all the associated pangs of regret.

But even if DCA makes us feel better, is the risk reduction worth it? This is the subject of considerable debate. Imagine a brother and sister who both receive a $500,000 inheritance, and both aim to invest the money entirely in the stock market. The brother invests his inheritance slowly, while the sister does so all at once.

Let’s start with three statements that, I hope, we can all agree on. First, during the period that the brother is spooning his inheritance into the stock market—when he effectively holds some mix of cash and stocks—he’s taking less risk than his sister, who threw everything into stocks right away.

Second, the brother ends up with a portfolio that, at the end of his gradual investment period, is just as risky as his sister’s. After all, both finish with $500,000 portfolios that are fully invested in stocks. Third, by investing everything right away, the sister will likely end up with more wealth, because most of the time stocks trend higher.

Based on the second and third statement, the anti-DCA camp dismiss dollar-averaging as irrational and contend that investors should invest their lump sum in the stock market right away. But I beg to disagree—for three reasons.

First, even if the stock market, on average, rises over time, there’s no certainty it’ll rise in any given period. We aren’t, alas, guaranteed an average result. Instead, we get just one shot at investing our lump sum.

Second, while the odds favor those who invest their lump sum in one fell swoop, we also need to consider the consequences of being wrong. If $500,000 is a pittance to our two siblings, investing the inheritance right away makes total sense. But if the $500,000 will make or break their chances of retirement, taking it slowly would be more prudent.

Third, dollar-averaging has an emotional appeal. Going slowly—even if it means missing out on a few percentage points of return—could be the strategy that delivers the best result. How so? The go-slow approach may give folks the courage not only to buy into the stock market in the first place, but also it might help them to stave off panic if share prices turn lower as they’re moving their money into the market.

The bottom line: DCA may be “irrational” and “sub-optimal” among the oh-so-clever folks who inhabit nerd world. But for a lot of everyday investors, it seems to work awfully well.