Why Dollar-Cost Averaging Stinks

A few months ago, I stated that it’s a good idea to invest in the market in small bites over time, rather than diving in all at once. This method is called “dollar-cost averaging,” and it’s a popular strategy in personal finance circles.

But a widening body of evidence suggests that you should dive in headfirst instead of dipping your toes into the market.

The Background

Dollar-cost averaging supporters say that if you pour every dollar into the market at the same time, you might accidentally buy at the worst moment, when the price is peaking. If you buy stocks in small increments over time, though, you spread out your risk.

For example, a person with $5,000 who wants to invest in The XYZ Index Fund might:

Invest the entire $5,000 on Jan 1 at a rate of $50/share. This is called “lump-sum” investing.

- OR –

Invest $1000 on Jan 1 at $50/share
Invest $1000 on Feb 1 at $53/share
Invest $1000 on March 1 at $46/share
Invest $1000 on April 1 at $48/share
Invest $1000 on May 1 at $48/share

Average cost per share? $49 dollars. You’ll also own more shares. The same $1,000 will buy you more shares when prices are low and fewer when prices are high.

Conventional wisdom says that this strategy — easing into the market — is the best way to invest.

After I wrote about this a few months ago, one Afford Anything reader brought some research to my attention. The research he encouraged me to read makes a compelling case that dollar-cost averaging might NOT be the best practice.

Rogue Research

In 1993, a pair of researchers from Dayton, Ohio imagined what would happen if they converted $120,000 from Treasury bills into an S&P 500 index fund.

They ran two scenarios: what happens if they invest the lump-sum on January 1, and what happens if they transition the money over the span of a year? They ran a historic analysis covering every year from 1926 to 1991.

The result? “Based on historical evidence … the odds strongly favor investing the lump sum immediately,” the researchers wrote. The lump-sum strategy won two-thirds of the time.

The following year, another research duo ran a similar comparison. They concluded that dollar-cost averaging “is mean-variance inefficient compared with a lump-sum investment policy.” That’s researcher-lingo for “c’mon, throw your chips in the game.”

Around that same time, a different research team showed that there’s no statistical difference between dollar-cost averaging and throwing money into the market at random intervals.

A bevy of other studies followed. By December 2001, a research team threw their hands up and said: Fine, fine. Maybe lump-sum investing helps you GAIN MORE. But does dollar-cost averaging help you LOSE LESS? In other words, is it a risk-mitigation technique rather than a growth technique?

They ran a study based on this question – and discovered that the answer is no. “We find loss aversion still does not explain the existence of the dollar-cost averaging strategy,” they wrote.

But Why?

What’s the problem with this seemingly-sound strategy? You miss the opportunity for gains when most of your money is sitting in cash or other low-risk vehicles. Over the span of a year, thatmissed opportunity is likely to cost you more.

There’s some evidence that suggests that the market tends to move in spurts. Missing a few critical days of gains each year will create a disproportionate impact on your portfolio.

Furthermore, there’s a low likelihood that you’ll happen to put your money in the market at the worst possible moment.

But here’s the most compelling “why” argument that I heard: Your asset allocation is wildly askew while you’re dollar-cost averaging. You’ll be disproportionately overweight in cash or cash equivalents during the year that you’re easing into the market. And as we all know, you’re at a huge disadvantage if your asset allocation is too far off-kilter.

The Bottom Line

It’s important to remember that this warning against dollar-cost averaging applies only when you’re comparing it to a lump-sum investment.

If you’re averaging into the market as you get paid, then you’re simply investing money as you get it. There’s no better alternative to that. You can’t invest money that you don’t have yet. Plus, dollar-cost averaging your paychecks won’t throw your asset allocation askew.

But if you happen to have a cool stash of cash lying around – perhaps from a tax refund or something else – don’t be afraid to toss it into the market immediately. Protect your asset allocation, not your averaging method.

From afford-anything.com