Why Dollar-Cost Averaging Stinks

dollar cost averaging or lump sum investingA 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, that missed 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.



Comments

  1. says

    DCA does not stink. What happens if you are the individual who happens to be in the 1/3 when lump sum doesn’t beat out DCA? If I said we shouldn’t be doing breast cancer research because the lifetime risk of getting it is only 12%, you (and many others would have a fit). That is less than the odds of DCA failure, but it matters when that person is YOU!

    So, if DCA helps with the emotional aspect of managing a large windfall, then I say go for it.

    • says

      @cashflowmantra – But, as the later study showed, “loss aversion still does not explain the existence of the dollar-cost averaging strategy.” In other words, you can lose a lot more money by using a DCA method. Based on the data, there’s no logical reason to use DCA.

      If someone wants to use it to manage the emotional side of investing, then they should be aware that they’re statistically likely to lose more money doing so. If they know that data, and they still choose to do it, then that’s fine. The problem is that most people are misled into believing that DCA is “safer.”

  2. says

    excellent análisis and article here AA, and spot on.

    What most DCA advocates overlook is that the method is a cash heavy allocation at the start that dimities over time creating in effect a fluctuating allocation.

    Besides, as you point out, most folks DCA as their cash flow allow for investment anyway.

  3. says

    Lump sum guy here, but I keep a certain percentage of cash as a dedicated asset as well. The key is what you are investing in. Your risk is inherently higher if you are buying individual stocks vs. just buying the market with some volitility calming bond allocation as well.

  4. Myrtle says

    We all know that every dollar is very important to us and we also make sure that we spend it wisely and in a smart way..

  5. says

    This is something I knew absolutely nothing about. I would have gone on any day attempting the dollar-cost averaging method since of course I am investing my own money. The alternative I guess should work just fine.

  6. says

    Hey Paula, I tend not to give a lot of credence to these hypothetical studies because many investors are emotional. For some edging in easily is comforting but you really hit the nail on the head when you stated that the market moves in spurts-it does! And if you miss those golden days your performance can really suffer.

    • says

      @Steve — Investing is a lot like eating: even if we know what we “should” do, most people don’t abide by the perfect ideal, since they make decisions emotionally. But that doesn’t mean we should stop trying to identify that ideal. It’s one thing to know that X is the optimal decision, but my emotions will lead me to choose Y instead. It’s another thing to mistakenly believe X is the optimal decision, even though it’s not.

  7. says

    Nice review on Dollar cost. I think if Dollar cost is not in a same area means average then market will up & down all time. At this stage some body will earn more & others will lost over night. Good post. :)

  8. says

    Most of us dollar cost average because it’s our only option. We don’t have some magic lump sum just sitting around to invest. Instead on payday we sink what we can into a 401k or IRA. Not disagreeing with the logic of the article, just doesn’t seem practical for most people.

  9. says

    Good stuff Paula, I’m definitely on your team on this one. If you have the lump sum? Invest it all at once instead of averaging into a stock.

    I’ve got to follow this up now, haha. Thanks for the read!

  10. says

    Great data presentation you have there. But even without those numbers, a person who monitors his financial status well doesn’t have thousands just laying down there. A smart(financially) person always goes for investments.

    For those who are starting out, the best option- the best option is this dollar-cost averaging. Time flies. After some months, the amount plus the interests may come in as a surprise.

    • says

      @MasterCard – That’s not true; lots of financially astute people end up with heaps of cash. A person might get an inheritance, sell his company for a cash lump-sum payout, or downgrade to a less-expensive home and pocket the difference.

  11. says

    I do value averaging. It works better than DCA – even better in a volatile market – like now. Diving in with huge lump sums is kind of silly though, good luck with that.

  12. says

    We seem to be over-looking transaction cost here. Etrade charges me 10 per trade so larger trades reduce this cost to my portfolio. Also, you will have to register with the SEC as a frequent trader if you trade too often.

    • says

      @Chase — Transaction cost is an important considerations if you’re buying individual stocks. You can avoid transaction costs by buying in-house index funds or commission-free ETFs.

  13. says

    I think I half disagree ;)

    the reason dollar-cost averaging works is because it allows people to “set and forget”, they don’t get wrapped up in market timing so can take advantages of the troughs when they come.

    the second advantage is that if it comes out of your account every month then you don’t spend it!

    the reason that property (in the UK where I come from) is seen as a rock solid investment is primarily because people “invest” (though their mortgage payments) regularly over a period of 25-30years. they automatically ride the bubbles and crashes

    for non-sophisticated investors the monthly automatic payment will work well.

  14. says

    For some people, DCA might be the best way to go because the amount is a little bit smaller to deal with each month and it’s not as emotionally charged as stock investments can be. These days, a lot of people aren’t getting inheritances, so they might have to work with smaller amounts. Good luck.

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