Ask the Spud: Should I Use Dollar-Cost Averaging?

In my latest podcast, I addressed a common question from both readers and clients:

“If I have a large sum of cash to invest, is it better to put it into the market all at once, or invest it gradually to take advantage of dollar cost averaging?”

Dollar-cost averaging, or DCA, is a strategy for investing gradually, with the goal of spreading out your risk and allowing you to take advantage of volatility. Many people seem to take it for granted that dollar-cost averaging has almost magical properties—that it reduces risk and leads to higher returns. In fact, while DCA can be a useful strategy, it’s often overrated—or at least misunderstood. So let’s consider when it might be appropriate, and what to expect if you use the strategy.

The two flavours of DCA

The first thing we need to clarify is that the term dollar-cost averaging can be applied to two quite different strategies.

The first is related to making regular contributions of new money, the way many people do with workplace savings plans. You might have $500 from every paycheque go into your group RRSP, and this new money then gets invested in a portfolio of mutual funds. Because you’re saving a fixed dollar amount with every paycheque, you’ll be buying more mutual fund shares when markets are down, and fewer when they’re up—which is a good thing.

The second type of dollar-cost averaging involves investing a large sum of cash, perhaps from the sale of a home or business, a pension payout, an inheritance, or some other windfall.

It’s really only this latter type of DCA that involves an actual decision. After all, if you’re a salaried employee who gets paid once or twice a month, what alternative to you have to gradual investing? If you want to save, say $6,000 a year, chances are the only way you can do this is to put aside $500 a month as you earn it. Whether these 12 contributions will lead to higher returns than a $6,000 contribution in January is a moot point, because that isn’t an option. Bottom line, it’s a great idea to make payroll contributions, but the benefit comes from regular savings, not from dollar-cost averaging.

So let’s turn our attention the more controversial strategy: investing a lump sum gradually rather than all at once.

Math meets psychology

Let’s say you receive an inheritance of $200,000 in cash, and that this represents a large share of your overall net worth. You can be forgiven for being nervous about investing a chunk of change like that all at once. If markets were to plummet in the following weeks or months, you’d suffer a punishing loss and would probably feel a deep, painful regret. So if you’re familiar with dollar-cost averaging, you might consider investing your lump sum gradually—say, in instalments of 25% separated by three-month intervals. That way if there’s an imminent market correction your losses will be reduced, and you’ll have the opportunity to invest part of your cash at lower prices.

Some investors believe that such a strategy is likely to result in higher returns, but the research is pretty clear that most of the time it won’t. Studies comparing DCA to lump-sum investing over various historical periods are quite consistent in their findings. A recent paper from Vanguard is typical: using data from the U.S., UK and Australia, the researchers compared the results of investing a lump sum into a balanced portfolio compared with using DCA over 12 months. In all three countries, the lump-sum strategy came out ahead about two-thirds of the time, regardless of the target mix of stocks and bonds.

Virtually all similar studies come to the same conclusion: DCA does not usually lead to higher returns. On the contrary, lump-sum investing is at least a two-to-one favorite, for the simple reason that markets go up more often than they go down. You put the odds in your favour when you invest money as soon as you receive it.

But that’s the mathematical argument, and it ignores the human factors. I’ve worked directly with many investors who have had six- and even seven-figure sums of cash to invest, and believe me, this is not an easy thing to do. You need an iron stomach, and academic studies don’t reduce the anxiety. Sure, the lump sum comes out ahead two-thirds of the time, but the other one-third of the time you could lose a huge amount of your nest egg.

Think of it this way: if you play Russian roulette you’ll win five times out of six, but I’m guessing those odds are not tempting you to play.

If you use DCA, do it right

So if you find yourself with a large amount of cash and you’re nervous about investing it all at one, there’s nothing wrong with using dollar-cost averaging. Just be clear that your goal is not to increase returns: it’s simply to reduce the stress and the likelihood of regret. Even the Vanguard paper above acknowledges that DCA usually leads to lower returns, but concedes that “these costs may be reasonable if a systematic implementation plan helps an investor overcome any paralyzing fears of regret.”

Note their use of the term “systematic,” because this is key. If you decide to use dollar-cost averaging, it’s important to draw up a plan for doing so. This plan should have nothing to do with the relative prices of stocks: for example, don’t tell yourself you’re going to invest 20% of your cash now and the next 20% only after markets have fallen 10%. Because it’s possible that prices won’t ever be 10% lower and you’ll continue to sit in cash while the markets run away on you.

Nor should you base your DCA strategy on specific events, such as “I’ll invest some now and some after the election,” or after the next central bank’s next interest rate announcement. Because the markets have already anticipated whatever you think is going to happen, and very often this turns out to be wrong anyway.

Whatever you do, don’t rely on vague criteria like, “I’ll invest the rest when things settle down and I feel more comfortable.” If you do that, you’ll find yourself in an impossible situation: if markets rise sharply, you’ll be worried we’re overdue for a correction. And if markets fall sharply, you’ll worry they’ll go down further. I’ve seen it happen, and it’s a recipe for paralysis.

Here’s an example of how to employ DCA more systematically. Say you have $200,000 to invest and you eventually want a portfolio of 60% equities and 40% fixed income. I suggest you start by investing all of the fixed income ($80,000 n this case). Although bonds can certainly move up and down in value, their fluctuations are very small compared with those of equities. So just go all in on the fixed income and use DCA with the $120 you plan to invest in equities.

Of that amount, invest $40,000 immediately, another $40,000 in three months, and the final $40,000 three months after that. Put that dates on the calendar and ignore the financial news on those days or you may try to talk yourself out of it.

Sure, if a bear market strikes in six months your portfolio will fall in value, but if you’re a long-term investor you need to be prepared for that at any time. If you’re not able to endure that kind of loss, then your 60% equity target is too aggressive.

Another caveat: dollar-cost averaging is not stress-free. Indeed, I like to say that it just turns one difficult decision into three or four. I have worked with investors who planned to invest a large sum gradually on specific dates and then backed out after the first or second tranche—they insisted on delaying the next installment until it “felt like the right time,” which of course, it never does.

Investing a large amount of cash is always going to make you nervous, and that’s OK. If dollar-cost averaging helps, then embrace it. It’s not optimal and probably won’t lead to higher returns, but having a structured plan in place does make it more likely that you’ll follow it through.

 

20 Responses to Ask the Spud: Should I Use Dollar-Cost Averaging?

  1. Rob Tait January 22, 2018 at 10:20 am #

    Seems like a reasonable approach to me. My $200,000 was $300,000 four short years ago. My advisor had me in Trident Global Opportunities Fund which is remarkably down in the past 10 years. I am in my early fifties and way behind on my goals and need to get on track. Of course being down by 1/3, the prospect of being down another 30% is cause for alarm so the DCA route is something for me to consider. Really bummed out as if I did a little work on my own, I should be sitting on a cool half million today and not as concerned that we are 10 years into a up market. Thanks for all your insights and I’ll try to stay off the ledge.

  2. Greg January 22, 2018 at 1:48 pm #

    Thanks, I was wondering about this topic for cashing out my pension before I hit 50 and putting it into a LIRA.

  3. Randy January 22, 2018 at 1:55 pm #

    In that boat right now, so very timely article.
    Thanks.

  4. Vikas January 22, 2018 at 3:20 pm #

    Thanks, I just started on my DIY couch potato portfolio, and invested 40k in a one day, in 4 ETFs. This article came as a thought reinforcement !!

  5. Greg January 22, 2018 at 3:49 pm #

    The thing is that you never know when the market will take a turn for the worse. Do you think nobody went “all in” the first half of 2008, or around 2000? The CAPE is higher now than in any point in history except 2000. It’s a gamble. Long-term, you’ll be fine, but short-term, there could be some serious pain.

  6. Darren January 22, 2018 at 4:16 pm #

    Dan,
    This lump sum investing issue comes up a lot in your blog. I’ve commented on it before, although I didn’t get much response. I still feel that there is another side to this argument that should be considered.

    Clearly, investors need an asset allocation with a risk level that they feel comfortable with. Logically, if someone is comfortable with the risk level of how their life savings are currently allocated, then they should also be comfortable with investing a new lump sum the same way. If they’re not, then there’s a problem.

    If you don’t feel comfortable investing new money according to your existing asset allocation, then you have too much risk. You need to come up with a new, lower risk asset allocation and invest your lump sum accordingly. If you’re still not comfortable, you need to keep lowering your risk until you do feel comfortable.

    I worry that having people invest a lump sum gradually serves only to move them into investments that are riskier than they are comfortable with.

  7. Canadian Couch Potato January 23, 2018 at 2:07 pm #

    @Darren: I don’t disagree with you in theory. But in practice it is very difficult to pull the trigger on a single large transaction, and so DCA can lower the anxiety, even if it does not lower the risk.

    Assume you held a 60/40 portfolio you had built up over the course of many years. Now assume you were all in cash before implementing a 60/40 portfolio yesterday. Over the next few weeks, the markets fall 10%. In which situation are you more likely to be filled regret and therefore likely to sell in a panic? Same person, same portfolio, but different situations can lead you to feel very differently about your choices.

  8. Oldie January 23, 2018 at 3:42 pm #

    I thought that, having carefully absorbed the essence of Couch Potato Wisdom at this site (1 you can’t predict the future, 2 Diversify at home and abroad wisely and cheaply 3 Choose an asset allocation that matches your life situation and which you can live with happily) there was hardly any more further practical information to learn here, nor the need for it.

    But you’ve further enlightened me again. This is a solid exposition in the hows and whys of DCA, and a telling example of the difference between sterile theoretical knowledge and gritty, practical I’m-glad-I was-shown-how type of advice!

    I really appreciate the careful distinction you make between the intent to increase the chance of gain (not), to decrease the risk of loss (not), and to reduce the likelihood of and worry about regret (yes) — a really subtle but essential distinction that I might have puzzled over forever on my own without being able to flesh out this human reality.

    The psychology of investing is quite complicated. It involves emotions and intuition, but the strategies to deal with it often turn out to be counter intuitive!

  9. SM January 25, 2018 at 12:04 pm #

    Great Article! I can see how DCA – in theory – makes lower returns over lump sum investing if there are no sudden market changes, and how @Darren’s argument makes sense, but I feel like I would still be hesitant to throw a huge sum of money into the market all at once.

  10. Oldie January 28, 2018 at 4:34 pm #

    Following the dialog between Darren and CCP, I see both points of view. I think it’s possible for both sides to be right. Darren is statistically and mathematically correct. If you have new cash, maximizing the probability of gain is achieved by investing immediately into your predetermined asset allocation, which, too be sure, was previously well thought over and has withstood the test of all possible thought experiments, and has come out satisfactory.

    CCP has pointed out the difficulty of applying theory to practice, and relates that in his experience with real life investors, lump sum investing often, maybe even usually, leads to considerable worry about potential loss. As Dan’s considerable experience attests, this distress, “irrational” though it may be, is very real. This worry can be mitigated by DCA strategies.

    However, Darren has thought long and hard through all this, and is driven by his faith in clean mathematical probabilities. In other words, his worry has been alleviated by his carefully thought out decision to live with his given fixed asset allocation. It’s not that he believes he is immune to loss. But he knows that with his preparation, thoughtfulness and final decision he has done everything he can to deal with the vagaries of the future and his emotions regarding this, and so he knows that he need not second guess himself, because he knows that he couldn’t come up with a better strategy, given that the future is unknown. Therefore he has immunized himself, as best as anyone can, to the crippling fear of regret that CCPs solution of DCA is intended to protect against.

    His comment also rings true about one’s long term asset allocation comfort zone not changing whether or not one has recently made a large contribution. Darren is likely to be a minority, but in that solidity of belief, is a “hard-core” Couch Potato.

    So, listening to both sides, both solid pieces of careful reasoning and advice, it really comes down to fully knowing yourself. Not what you should be able to live with, but what you truly think you can live with. Believing and accepting the CCP philosophy was a difficult enough leap from the commonly held intuitive belief system that surely one can glean useful clues about the future, especially if you can find enough highly paid experts. So maybe residual worry about lump sum investing merely represents lingering belief that we “should” know how better to invest in the short term without initially committing too much of our capital, although we had, with another part of our brain, earlier established that we could live with such-and-such asset allocation. We should not beat ourselves up with this cognitive dissonance, if that’s indeed what we have. That’s just what what our belief system is capable of, for now. Choose the appropriate strategy that is kindest to your system.

  11. Darren January 28, 2018 at 5:47 pm #

    @Dan: Fair enough. You deal with people in this situation a lot; I only have myself to deal with.

    @Oldie: I wasn’t trying to suggest that I’m rational and Dan’s clients aren’t. My point is that maybe people who fear investing a lump sum according to their existing asset allocation are being perfectly rational – they just have too much risk.

  12. Oldie January 29, 2018 at 1:06 am #

    @Darren: No criticism was implied towards thinkers of either camp. Neither would I denigrate anyone that in this context could be described as “irrational” or at least “inconsistent”. There’s nothing wrong or inferior about being so, although it may lead to discomfort or worry. If one’s thoughts are thus, then that’s what they are, and one has to deal with it. DCA appears to be a reasonable way to do so.

    But I also appreciate your further comment that seeks to align rationality a little further — the fear of the investor that seeks DCA as a protection from worry could really be a symptom of having too aggressive an asset allocation mix for comfort, without the investor being aware that this is so. I really can’t find a reasonable logical argument against that.

  13. Dan January 29, 2018 at 5:25 pm #

    What about value averaging? I just read the four pillars of investing by William Bernstein, and he recommends investing a lump sum over 2 to 3 years with quarterly additions based on maintaining a prespecified value of your asset and allocations as opposed to fixed dollar amount inputs.

  14. Canadian Couch Potato January 30, 2018 at 1:37 pm #

    @Dan: I suppose that’s fine, although I think two to three years is probably too long to drag it out.

  15. Greg February 1, 2018 at 8:59 am #

    Did you see this?

    https://www.vanguardcanada.ca/individual/etfs/about-our-asset-allocation-etfs.htm

    Sounds like a serious contender to replace Tangerine in the One Fund solution.

  16. Donna February 1, 2018 at 5:10 pm #

    Ooh.. interesting. That really appeals to me for several reasons. Love to get your take on that Dan vs the 3 fund CCP model especially since there are a couple of cad hedged in the mix. I love simplicity in my life wherever possible.

  17. Jungle February 3, 2018 at 5:11 pm #

    Going back the last 20 years there were two periods where investing lump some didn’t work out so well: early 2000 and 2006/2007

    But yeah, really hard psychologically.

    If I was worried so much and had decision I would invest somewhat conservatively with maybe 30-40% bonds so I wasn’t worried so much about making a mistake if bear market comes.

  18. caltran February 4, 2018 at 2:47 pm #

    Any chance you can take a look at the new Vanguard all-in-one ETFs? Specifically backtesting returns?

  19. Brian February 23, 2018 at 12:41 pm #

    Kind of depends on where the overall markets are in a particular cycle. DCAing when ‘the markets’ are at all time historical highs would seem to make sense, especially during the Trump Effect laced with geopolitical turmoil. Only an idiot would deploy 200K of new money, never been exposed to the stock market in January or February of 2018 in a fund or stock at what is likely the highest point ever? Now, since the markets always with 100% certainty reach new historical highs eventually, then lump sum depositing money never exposed to 100% equities when the markets are lower than their historical highs will be a better risk over time. That said, a 20% loss requires a 30% return just to stay even, so averaging into anything at anytime is just prudent to take unfortunate timing off the table in some way.

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