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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.
Great piece, Jonathan! “Irrational” is a great option for us irrational creatures. Here’s a different perspective, but similar message on DCAing: https://open.substack.com/pub/buddhishinvestor/p/would-the-buddha-time-the-market-50f?r=lw3m7&utm_campaign=post&utm_medium=web
Most of us invest when we have the money. All things being equal, the more time in the market usually results in greater returns. So, lump sum investment would seem better. That being said, if I like a stock and think it is undervalued I tend to invest a little more when the price goes down.
Over the course of most of my working life I never had the benefit of any lump sum. Dollar cost averaging a certain amount of my pay into IRAs and education funds for my four kids was how we got ahead. Where it can really benefit the investor over time is periods like 2007-2013. In rough numbers, the market peaked in the fall of 2007 with the SPY (S&P 500 Index fund) reaching about 155. It later dropped to about 65 in March 2009, then got back to 155 in March of 2013. That was quite a gut check for the intrepid investor, however, if you hung in there and kept DCAing, well, you would have found yourself doing a whole lot better than most by 2013. DCA’s ability to allow one to profit from the dips, over time, in an ultimately rising market is what makes it so appealing.
Had you made a $100,000 investment in the S&P on March the 9th, 2009 in March of 2013, you would have had $238,000. Had you made a $100,000 investment at the previous index peak of 155, you would still have your $100,000 at the next peak in 2013. BUT, it would not have been a pleasant 4 years. Since we cannot know the timing of the peaks and valleys, DCA is attractive. But with investing when you have moved a large sum from a 401k to an IRA, you might DCA over a year or so. It is still chance as to how the market is moving when you do so……
DCA addresses a risk but not the one we most think about. We often equate stock market volatility as risk, but that is only true for people who invest in stocks and have a short (<~10 year) time horizon. Over long time horizons stock market volatility isn’t a big risk. The real risk is the investors response to market volatility, i.e. panic selling due to an emotional response to the stock market “loss”. Alot of folks sell at a loss in these situations and then don’t reinvest at all or wait until the market has gone back up above their selling point which is counter-productive.
This was drilled home for me in the early 2000-2008 time period when we were getting our footing professionally and financially. 4 of those 9 years had significant negative yearly returns. It was tough to keep investing our 401K dollars into the stock market and not sell. There were months where the value of our 401K’s were dropping faster than we could put money in. However, the people who stuck it out have been rewarded by the returns of the last 16 or so years.
The key things to remember during these declines:
1) You are buying low – which is what you want to do.
2) You only gain or lose in the stockmaret when you sell. If you don’t sell you haven’t lost.
3) This is long term money and the stock market is your best investment for the long haul.(assuming you have 5-10 years of expenses in cash and bonds).
I thought “we” had put this to bed…
I’ll let Nick Maggiulli https://ofdollarsanddata.com/dollar-cost-averaging-vs-lump-sum/
Beyond DC pension contributions I’ve always bought into other funds at about 5k a slug over time. First it was a good way of wetting my feet when I decided it was time to get serious about future retirement and then it seemed a sensible amount that kept trading cost under control. Now I think I’m broadly settled on cash equivalent level I try to clear out this amount of residual on the regular.
Of course retirement will bring an end to this as income ceases and my financial life becomes where to draw from in what order and rebalancing rather than new money. Though I do have a warchest of cash as dry powder to help me feel better to buy in a major market downturn. Whether that actually makes economic sense or is just a mental safety net is open to question.
I’ve had a couple of opportunities for this decision. In both cases, I went all in without much thought. But the amounts weren’t huge, and I knew the money was for a far-future purpose. If the money had a bearing on something as important as retirement income, I’d probably space out the investing.
My wife and I are taking a similar tack with trimming our fund list down to one or two total market funds. Rather than converting all at once, we’re following a plan to do it over a 4 or 5 year period. But Yeigh-like impatience may move us to just make the mouse-clicks to be done with it at one go.
I’ll throw another theory at you…50%. Invest 50% now and the rest later. Alan Roth has proposed this as reasonable:
https://www.advisorperspectives.com/articles/2024/08/29/50-percent-rule-allan-roth
Personally, I prefer the lump sum and that’s what I’ve done for the last 30 years.
Another blow against DCA…
https://www.etf.com/sections/advisor-center/etf-truths-morningstar-gap-survey-allan-roth
I read the article cited above. It really doesn’t deal with the subject of dollar-cost averaging.
It does discuss the performance gap between fund returns and investor returns. The poorer performance of the latter is mainly due to some investors trying to time the market by selling or purchasing fund shares based on a reading of the economy.
Dollar-cost averaging the same amount of money on a regular schedule ignores the state of the market. It doesn’t try to time anything, but accepts that fewer shares will be purchased when the market is up, and more shares purchased when the market is down.
Jonathan’s post contrasts DCA with lump-sum investing. But whether you choose DCA or lump-sum is a consideration open only to those with a lump sum to invest. If you invest a portion of your earnings with each paycheck, lump-sum investing is a moot point and DCA is your only option.
I made my first venture into stocks about 2 months before Black Monday. My huge 2k investment plummeted in value. Panic made my stomach feel like it was in my throat. Then things quickly turned around, and all was good in my world again. I learned my lesson and haven’t lost a night’s sleep over market gyrations since.
What would I do with a windfall? Today, with the market at an all-time high I would DCA. If the market looked like it did in 2008 I’d have no problem going all in.
Here’s a good analysis showing lump sum beats DCA about 80% of the time:
https://ofdollarsanddata.com/lump-sum-investing/
Despite knowing this, I initially started to trickle my pension lump-sum payout into the market (DCA) over a planned one-plus year time period. This was good for sleep and protected against Sequence of Returns Risk.
As the market continued to creep up in 2017, impatient-me suddenly pivoted to a nearly all-in with the lump sum after maybe 4-5 months. So much for my well-thought-out and rational pre-planning.
One other scenario where dollar cost averaging comes into play is with Roth conversions. We are currently converting all of my wife’s multiple six figure traditional IRA from a target date fund to Vanguard Total World Stock Index ETF Roth. This conversion is changing from a fund with a significant portion of bonds into an all stock fund (I am compensating for this by increasing the percentage of bonds in my traditional IRA to maintain our target allocation while making these funds we are utilizing now potentially less volatile).
This is being done for several reasons. First this way when we both turn 73 in several years we will only have to take RMDs from one account. In the meantime while delaying Social Security we will only tap my traditional account to pay for expenses thus decreasing my RMDs in the future.
Second with my wife’s family’s history of centenarians there is a good chance that she may need to tap these funds in her 90s so it will have years to increase in value, or a significant portion of the Roth funds will be inherited by our children tax free.
By dollar cost averaging on a monthly basis I feel better knowing that I am spreading my “bets”. Plus when it comes to the December conversion I can wait until the last week of the year to make the final conversion amount to bring the total conversion to the maximum dollar amount in the tax rate I am targeting.
Great post concerning something that is often causing people to lose sleep.
My fiancé is currently dollar cost averaging a lump sum from managed funds into her IRA with low cost index funds. It makes it automatic for her at 10k per month and she never looks at the balance. It has been in a 5% Money market fund until invested. The pundits like to tell investors to lump sum invest the funds, but they’re not the ones losing sleep.