The Real Benefit of Dollar Cost Averaging
What would you do if I gave you $100,000 in cash to invest? Would you go “all in” and invest the whole thing up front? Or would you be worried that the market could drop and you’d lose money? If you found yourself leaning towards the latter, then most financial advisors might recommend that you dollar cost average your way into the market to minimize your risk of losing money. While on the surface this may seem like an appealing advantage of this investment strategy, I think there is actually a deeper, hidden benefit that could have a much more substantial impact on your portfolio as well as on you as an investor.
What is Dollar Cost Averaging (DCA)?
Dollar cost averaging is a strategy used to invest an available sum of money by dividing it into equal investment installments over a given period of time. It is not the same as purchasing a fixed dollar amount of a particular investment on a regular basis, which is periodic investing. For example, automatically contributing to your 401k every month with each paycheck is not dollar cost averaging; rather, that’s just investing your money as you get it. Dollar cost averaging would be if your employer gave you $18k of your salary in one lump sum in January, and you then decide to break that up into $1500 investments every month over the course of 12 months. DCA is an alternative to making a lump sum investment all at once.
Dollar Cost Averaging as an Investment Strategy
DCA is proposed as a strategy for investors to reduce the risk of loss in a market downturn by “buying in” over time rather than up front all at once. This would be ideal for the risk averse investor who is concerned about suffering a loss on an initial lump sum investment. With dollar cost averaging, you invest the same amount of money at regular intervals, regardless of the cost of your investment, until the DCA period is over.
As an example, let’s compare two investors who have $40,000 in cash available to them. They both decide to invest in an S&P 500 fund for $50 per share at the beginning of the year on January 1. Investor A goes with a lump sum investment while Investor B decides to dollar cost average over the course of 12 months. They decide to invest $10,000 every three months starting January 1. For this scenario, let’s say the market declines and the price of the fund drops by $5 every three months and ends the year at $35 per share. At the end of the year, both investors suffer a loss, however the DCA investor’s decline is roughly 14% less than the lump sum investor.
This scenario is ideal for dollar cost averaging, and it does highlight a potential benefit of this particular strategy. I can see how it might be difficult to stomach a 30% drop in your investment. I can also see how someone might sell and “lock in” this loss, particularly an investor who couldn’t tolerate this amount of risk to begin with.
Lump Sum Investing Outperforms Dollar Cost Averaging
While DCA worked out well in this hypothetical case of a single market decline, in the real world we know that the overall trend of the market is up. If this is the case, does lump sum investing (LSI) outperform dollar cost averaging? The short answer is yes. In fact, a study by Vanguard illustrated this point using historical market data. In the study they compared a lump sum investment versus dollar cost averaging of $1 million in cash. For the DCA strategy, they made regular investments over a period of 6, 12, 18, 24, 30, or 36 months. They used historical monthly stock and bond returns with an investment time frame of 10 years. They analyzed rolling 10-year periods from January 1926 to December 2011 and found that lump sum investing led to higher portfolio values in roughly two-thirds of the periods analyzed. There were also a number of other details and findings that I’ve listed below, bullet point style.
- Both strategies had identical asset allocations once the DCA period was complete
- They analyzed various asset allocations from 100% stocks to 100% bonds
- Studied various investment time frames from one to 30 years
- LSI outperformed DCA in a greater proportion of time periods regardless of the DCA length; as the DCA period lengthened, the greater the probability of lump sum investing outperforming dollar cost averaging
- LSI had higher returns even when allocations were 100% stocks or 100% bonds
- On average, LSI had an ending portfolio balance 2.3% greater ($2,450,264 versus $2,395,824) than DCA for 60/40 stock/bond allocation after 10 years (difference of $54, 440)
- LSI provided better returns on average even when adjusting for risk, measured using the Sharpe Ratio
- DCA performed better during market downturns (as we’ve seen already from the previous example above)
- Out of 1,021 rolling 12-month periods analyzed, LSI had a decrease in portfolio value during 229 periods (22.4%) while DCA had declines in 180 periods (17.6%)
The results of this study shouldn’t seem that surprising. After all, a DCA portfolio is more conservative until it reaches its target asset allocation given its cash holdings. And yes, historical returns and averages are only a guide and no one can predict the future when it comes to the markets. However, over it’s history, the overall trend of the market has been up, and this tends to favor a lump sum investment over a DCA strategy.
Postponing Risk Now For Risk Later
The title of the Vanguard article makes a good point. Dollar cost averaging really is just taking risk later. After all, once the DCA period is over you will be at you target asset allocation and fully invested in the market. At this point you’ll be exposed to the same systematic risk that was there before. In the end, you’ve just substituted market risk at one point in time for another.
The Real Benefit of Dollar Cost Averaging
Knowing that lump sum investing is more likely to outperform dollar cost averaging over time and that systematic risk will always be there, what would you do with that $100,000 I gave you? Would you still prefer to dollar cost average in order to minimize your risk of losses? If so, therein lies the real benefit of dollar cost averaging. It gives you a reality check. Perhaps you need to re-evaluate your risk tolerance and your asset allocation. If you’re worried about losses in the event of a market downturn, then perhaps you’ve overestimated your risk tolerance as I think most investors are inclined to do. And if you’ve overestimated your risk tolerance, then maybe your asset allocation is a bit more aggressive than it should be. So if you’re ever in the position to invest a nice chunk of change, whether it’s an inheritance, a holiday bonus, or your tax refund, choosing between lump sum investing or dollar cost averaging isn’t the most appropriate thing to do. Rather, you should reassess your risk tolerance and asset allocation and adjust it so that you’re comfortable making a lump sum investment to begin with.
Readers, have you ever found yourself having to decide between lump sum investing or dollar cost averaging? Do you think you have a realistic measure of your risk tolerance? Any other thoughts or comments? Sound off below.