Did you know that dollar cost averaging - the practice of investing your money gradually over a period of months or even years - only beats investing a lump-sum immediately one-third of the time?
To be clear, we're not talking about the practice of consistently and automatically investing a portion of your paycheque into your portfolio. Mercer Invest Wise is a strong advocate of that strategy because it allows you to drown out the noise and save for your future with discipline.
We're referring to situations where you may have a significant chunk of money to invest relative to the size of your total portfolio. It could be from an inheritance, commuting a pension, or from the sale of your home or business. Maybe you've accumulated savings in a bank account and are just looking to get started with investing.
Dollar cost averaging is often touted as the best way to deploy large pools of cash into the markets because it reduces the risk of investing all of your funds at what later turns out to be a market top. The problem is that it could also leave you with cash on sidelines while the market is rising. And it's just as costly to miss out on a gain as it is to incur a loss. Since stocks and bonds have outperformed a bank account by a wide margin over the past century, it's more likely that you'll miss out on gains than avoid losses.
The latest research on the topic comes from indexing-giant, Vanguard, which recently put out a study (PDF) confirming what other past studies have already shown. Namely, that investing your money all at once right when you get it - instead of dollar cost averaging it over the course of a year - would have left you better off in about two-thirds of all historical 12 month periods. This result was consistent in the U.S., the U.K. and Australia. It was also true for portfolios with varying combinations of stocks and bonds.
The average outperformance from investing a lump-sum in a portfolio with 60% stocks and 40% bonds was approximately 2% a year. In other words, you might expect to gain an extra $2,000, on average, by immediately investing $100,000 instead of deploying it gradually over the course of a year.
Here is how Vanguard presents their findings:
Does this mean dollar cost averaging is always a bad idea? Not necessarily. Research shows that humans feel the sting of losses more intensely than the joy of gains. If the thought of investing your money all at once - and potentially seeing it fall in value shortly afterwards - fills you with anxiety and paralyzes you from investing it at all, then dollar cost averaging can make sense. Paying a price - in the form of expected forgone returns - for peace of mind can be rational in the same way that it is rational to pay for goods or services you derive benefit from.
If you choose to dollar cost average, plan to get your funds invested within a year. The odds of dollar cost averaging outperforming a lump-sum investment decrease significantly the longer you take to get your money to work. According to an earlier Vanguard study, dollar cost averaging over a three year period, for example, has only outperformed a lump-sum investment in about 10% of historical periods.
In addition, don't succumb to the common pitfall of starting a dollar cost averaging plan only to abandon it before completion because of the way markets have moved. You'll end up holding cash much longer than you ever intended and that will drag down your returns. The best way to avoid this fate is to set up a series of pre-authorized contributions. That way, you will have less temptation to bail on your plan or tinker with the timing of your investments.