February 26, 2018
Some investors, who are not comfortable with the risk of investing a lump sum all at once, might consider dollar-cost averaging (DCA), which involves putting money to work over time by systematically investing a fixed dollar amount at regular intervals. DCA may seem advantageous because it spreads risk across multiple entry points, but does it create better long-term results? Investment theory and empirical evidence support investing large sums of cash immediately.
Stocks and bonds typically have a higher expected return than cash. This is why the earlier you invest the cash, the better (on average). Also, investing all at once reduces transaction costs.
A Vanguard study1 found that immediately investing outperformed DCA 64-92% of the time, depending on the investment interval. The longer the DCA window, the more frequently an immediately-invested portfolio outperformed. The study also looked at the degree by which immediately investing has historically outperformed DCA. Using 60% stock/40% bond portfolios, it found that immediately-investing outperformed by about 1.5-2.5%, on average, over 12-month intervals.
Investors who choose DCA are typically more concerned about worst-case scenarios in the markets rather than average outcomes or probabilities. We recognize that investing is an emotional process, so for investors who seek downside protection, DCA can be a reasonable solution. If a large drawdown were to occur soon after investing, DCA would likely outperform due to still having a portion in cash. In such instances, DCA may make it more likely that investors would stay the course and remain invested. One of the most harmful things to long-term success would be to invest immediately and then move back to cash upon encountering a downturn. DCA can also help investors who are hesitant to make an initial investment to overcome that initial fear of loss and prevent further postponement of investing.
Investors who do decide to invest their cash systematically (i.e., DCA) should first make sure the investing is actually done systematically, rather than as a series of separate decisions, each with its own potential for regret. Such an approach imposes the necessary self-control to ensure that the money is fully invested in a timely manner. Postponing implementation during rough market patches can be incredibly detrimental to the odds of investment success. Second, keep the timeframe for DCA to less than one year. The longer the investment window, the more likely DCA will negatively impact returns.
In conclusion, we view DCA as more of an emotional or psychological support than an investment planning step. We believe investing a lump sum immediately is generally best practice. However, in some instances, DCA may be appropriate for investors who have a stronger Fear of Loss (FOL) than Fear of Missing Out (FOMO). In a way, DCA is similar to insurance: its expected value is normally slightly negative, but it spreads risk across multiple entry points. As long as you understand that DCA will likely result in lower returns, it really comes down to your specific investment preferences. We encourage you to speak with your advisor to find out whether your situation would benefit from DCA.
At Ronald Blue Trust, we provide investment strategies that are designed to help increase the probabilities of meeting your financial goals, taking into account your risk preferences and time frames. For more information, please contact your Ronald Blue Trust advisor, call 800.987.2987, or email [email protected].
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1Berkowitz, Daniel B., Andrew S. Clarke, Christos Tasopoulos, Maria A. Bruno, CFP, “Financial Planning Perspectives: Invest Now Or Temporarily Hold Your Cash?” 2016, https://personal.vanguard.com/pdf/ISGDCA.pdf.