Is Dollar-Cost Averaging Right for You?
One of the most basic pieces of advice in personal finance is to utilize a strategy called dollar-cost averaging to enter a position. Today, I want to discuss what that means and whether it is the right strategy for you.
Dollar-cost averaging is the periodic investment of a set amount of money into the market, regardless of whether the market is going up or down. For example, if you have a fixed amount of money going into a 401k each paycheck, you are dollar-cost averaging.
In this case, you are simply investing money as it becomes available. It is dollar-cost averaging as the most convenient means of investing.
But what if you suddenly receive a lump sum of money? Is it better to invest that lump sum into the market, or should you dollar-cost average?
A Case Study
Let’s consider what could happen. If a relative gave you $100,000, and you happened to dump that money into an investment just before a market correction, you could see that investment dwindle quickly.
For example, if you invested $100,000 into an S&P 500 index fund in February 2020, a month later you would have had $68,000. This is the scenario dollar-cost averaging is designed to avoid.
The market did recover quickly following that 2020 crash, so by the fall of 2020 you would have been back to $100,000 (assuming you didn’t sell in a panic during the crash).
But, consider if you had decided to dollar-cost average into this position. There’s no set rule on how long you should move a lump sum into the market, but let’s say we want to do it over 10 months.
So, in mid-February 2020 we invest $10,000 into an S&P 500 index fund trading at $100 a share. That works out to be 1,000 shares. In mid-March, that $10,000 has dwindled to $6,800, but we still have a total of $93,200 instead of the $68,000 we would have had if we invested the lump sum.
But now in mid-March we invest another $10,000. Because the price of the fund is depressed, this $10,000 investment buys us more shares. Our March purchase would have bought 146.6 shares. This is the appeal of dollar-cost averaging. When shares are down, your fixed investment buys more shares. This can reduce some of the emotions that might impact your willingness to invest in a declining market.
By mid-April, the recovery was underway. Shares had gained 23% in a month. In fact, the $20,000 you have invested thus far is now worth $20,694. In other words, you are back in positive territory months faster than you would have been if you had invested the lump sum.
Given this example, why would anyone put a lump sum into the market? Primarily because most of the time the market is rising. A 2012 study by Vanguard looked at the impact of investing your money in a lump sum vs. dollar-cost averaging. The study found:
“In this paper, we compare the historical performance of dollar-cost averaging (DCA) with lump-sum investing (LSI) across three markets: the United States, the United Kingdom, and Australia. On average, we find that an LSI approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments. This finding is consistent with the fact that the returns of stocks and bonds exceeded that of cash over our study period in each of these markets.”
Most of the time, the lump sum approach will be best. But you may still want to dollar-cost average if the following situation applies. If this lump sum amounts to most of your savings, and it would be very hard or impossible to replace, you should opt for dollar-cost averaging because it’s the safer approach.
I often advise investors not to take risks when they can’t afford the downside. Here’s a story that illustrates this concept. Let’s say you have spent years saving $100,000. It is the entirety of your savings. Then someone comes along with an offer. They will flip a coin. If it’s heads, you get a million dollars. If it’s tails, you get nothing. Do you take that gamble?
No, despite the potentially large return, you can’t afford a risk like that if it could wipe you out. Don’t take a risk if you can’t afford the consequences if they go against you. This is a life-changing coin flip in either direction, but only one of those directions is good. Now, if you can easily make up $100,000, or it’s not the bulk of your savings, you absolutely take that risk, because you can afford the consequences if the risk goes against you.
That’s the bottom line with dollar cost averaging. The lump sum will be the best strategy most of the time, but only if you can afford to take that risk. If this amounts to all your savings, it’s more prudent to be cautious.
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