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

2018-05-29T22:15:14+00:00January 22nd, 2018|Categories: Ask the Spud, Research|Tags: |21 Comments

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.