A general investing maxim that has been passed down over the years is that Dollar Cost Averaging (DCA) is a good way to invest, particularly for beginning investors.
The basic approach is that you invest a consistent amount at regular intervals, which ensures that you buy more shares when prices are low (and fewer shares when they’re higher). You use DCA every time you make a 401(k) contribution, and with any systematic investments you make to an IRA, 529 plan or a taxable investment account. Chances are you doing DCAing now, whether you realize it or not.
Let’s say you’re a new parent of triplets. As a Christmas gift, Grandma and Grandpa have very generously given you $12,000 to invest toward the triplets’ college savings fund. You’ve decided that since college is 18 years down the road, investing it all in the stock market is a smart decision. For the sake of simplicity, you’ve decided that the Vanguard Total Stock Market ETF (VTI)* is a good way to do that. Do you invest it all up front, or “average in” over the course of the year?
If you had invested on the first trading day of this year, you would have paid about $65.38. If, on the other hand, you would have invested on the first Monday of each month for 12 months, your purchases over the first six months of 2012 would have averaged $69.22, as shown in the chart below.
[highlight]For the sake of clarity, I’m assuming all purchases were made at the closing price. I’ve left the other prices in the table because it’s a good illustration of the volatility of even a broad market index throughout a given day.[/highlight]
As implied above, probably the most logical comparison to make is between DCA and lump sum investing. If you don’t have a lump sum available to invest at the beginning of a period, but want to invest on an ongoing basis, you will end up dollar cost averaging by default.
Back to our example, though: should you have invested that $12k on January 2, or deployed $1k once every month?
While DCA may feel better to a lot of investors, the fact is that historically it has not resulted in better aggregate returns. If you had $12,000 ready to invest at most points in history, you’d be statistically better off putting it all in the market rather than averaging in over time. Why? Because the market typically goes up. I know, I know, it doesn’t seem like it, especially after spending any quality time with news sources like CNBC. However, between 1970 and 2010 most sectors within the stock market showed a loss in only 7-9 of the 40 years, depending on the sector. Since 1926, it’s more like 20 years, out of 84. At the risk of sounding overly technical, the stock market goes up more than it goes down. It doesn’t take a lot of math to conclude that investing a lump sum at the beginning of a period will generally do better than spreading it across a series of investments over a number of months or years, if that investment is increasing in value. Of course, you may not want to break that data out at a cocktail party with somebody who went all-in in May of 2008.
There are other considerations. Investing the lump sum is more obvious for the dividend enthusiasts among us. Waiting to get into the market could mean foregoing dividend payments. Those dividend payments can be reinvested, and over the long run they will contribute significantly to the overall returns of a stock market investment.
A Dollar Cost Averaging approach to investing matches up nicely with most savers’ ability to invest. Not many of us have a pile of cash sitting around looking for a place to go. In the spirit of Yogi Berra: if such a pile exists, and we invest it, it no longer exists. Systematic investing makes a ton of sense, and that implies that DCA is at work. The discipline and forced savings that accompany such an approach are key components of building wealth, and in that sense Dollar Cost Averaging makes a ton of sense.
For investors who are experiencing anxiety about a given market environment, as many are today, it also might make sense to choose DCA over lump sum investing. Instead of exposing all of a lump sum to a significant market drop, the investor can lose less and systematically take advantage of lower prices if the drop occurs. On average, this is not a superior approach, but if such a drop happens it might actually improve subsequent investing behavior. Investors are rarely served by trying to eke out every last dollar of return. The behavioral aspects of investing are critical and often under-weighed by investment advisors. For instance, if DCA would have led more people to stay invested through 2009 after getting hit hard in 2008, we’d have more people closer to retirement than is currently the case.
*Not a recommendation to buy a specific security.