Historically, the stock market has exhibited two characteristics: its returns are volatile and the overall market trends up over long time periods. Dollar cost averaging is an attempt to take advantage of these characteristics by investing a set amount of money at a given time interval. With this approach, you are buying more shares at a lower price when the market moves down, and the long-term upward trend means that your shares will eventually increase in value.
There are two different scenarios in which you might consider dollar cost averaging. In one, you start with no money to invest but with the ability to make future deposits. For example, let’s assume that you have a goal to invest $10,000 in the stock market. You don’t have the money now, but can invest $1000 per month going forward. Your quandary is whether to deposit $1000 each month for ten months, or to wait a few months for a more propitious moment to invest. The first approach – which is really just a regular savings plan – gives you the highest likelihood for success. It avoids the temptation to time the market, which might work on occasion but is likely to cost you money in the long run.
In the second scenario, you already have the money to invest and are trying to decide whether to deposit it right away in a lump sum or to spread it out over a period of time. The appeal of dollar cost averaging in this setting is that you avoid the risk of a huge drop in the market occurring immediately after you’ve invested your lump sum. While this makes intuitive sense, it does not hold up to rigorous scrutiny. Dollar cost averaging was shown to be a flawed strategy 30 years ago in the Journal of Financial & Quantitative Analysis. (1)
Since then, numerous academic studies have confirmed this analysis. An immediate lump sum investment not only provides a higher expected return than dollar cost averaging, but does so with slightly less risk.
So why do so many people persist in dollar cost averaging? The answer comes from the world of behavioral finance, which integrates insights from psychology into economic science. According to behavioral finance theory, investors prefer an error of omission to an error of commission. If you dollar cost average and the market goes up, you would have been better off with a lump sum investment but you have relatively little regret over the action not taken. On the other hand, if you invest in a lump sum and the market tanks, your regret is much more intense. Stated another way, your chances of a bad investment experience might be higher with a lump sum investment, even though your expected returns are better.
If you are sitting on a pile of cash, my advice is to follow the superior strategy and invest it right away. This gets you into your best portfolio as soon as possible. If the psychological lure of dollar cost averaging is too great, I suggest using a relatively short time interval between deposits (e.g., monthly) and a short overall time horizon (such as 6 months).
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
(1) Constantinides GM. A note on the suboptimality of dollar-cost averaging as an investment policy. Journal of Financial and Quantitative Analysis, 1979, 14: 443-450.