As you might expect, we get questions about dollar cost averaging (DCA) frequently. Would it be better for the client if we invested a large sum (typically cash) gradually over several months, or even a year or two? Or, should we simply move into a fully invested position as soon as possible, subject to available liquidity?
Our conclusion is that while conventional wisdom—and human nature—says that DCA is the more rational approach, the reality is quite different. For our complete analysis, see our white paper “Dollar Cost Averaging: Does It Work?”.
Our Starting Premise
The most obvious and probably most important principle with investing is to accurately assess what you know and do not know. If you do not know something, do not go there. The market is an expensive place to learn.
The second most important principle with investing is to define the time horizon. How long do I anticipate being a risk-taking investor? If not long term, again, do not go there.
At CornerCap we find these principles easy to define and to follow. Considering the general upward bias of the markets over time, it is generally assumed that stocks will deliver positive returns over the next 20-years—and perhaps over the next three to five years, although this shorter period is much less certain. Regarding what is not known, we do not believe that we can predict the market movements in the near term (or that anyone else can). With investments, you win by being there—not in searching for when not to be there.
The Actual Economics
In our white paper, we looked at market index returns over the last 37 years to determine whether DCA is better to follow rather than a lump-sum (LS) approach.
What we found was that DCA generally wins only one-fifth to one-third of the time in an all-stock portfolio, and even less with a balanced portfolio. In addition, the lump-sum approach tends to offer better returns than DCA, on average. And, the longer it takes to get invested under DCA, the worse the relative returns tend to be.
We should note, in completeness, that DCA tends to perform better on those rare tail events when stocks drop a lot. But the probability of these extreme drops is low—about 4%-5%. Why manage to the extreme downside, but lose the positive benefits under most scenarios? If the rare extremes are of concern, we would argue that putting funds into stocks at all does not make sense for you.
Our analysis highlights that market timing is extremely difficult and that being in the market is better than being on the sidelines, if you have a long term horizon.
The Human Factor
Assuming that the market will grow over time and that there is no way to predict where the market is headed over the coming months, why would any investor dollar cost average into the market over several months? As is frequently the case, human emotions can get in the way. Here are the typical reasons:
- To allay the client’s fears of quickly losing money. Losing money in a down market is much more emotionally draining than “not making as much” money due to being absent from an up market. Over time dollar averaging into the market will lessen the return of the average investor. However, the peace may be worth the price.
- To avoid the adviser’s concerns for having a rocky start to a hoped for long term relationship. We try to assess how a new client might react to a sudden drop in the market. Of all the passions, we know that fear weakens judgment the most.
When we managed the RJR Nabisco pension fund, we were being evaluated by an outside consultant. Understanding the above principles of investing, whenever we had new assets moved to our in-house investment operation, we were given 30-days to get where he wanted to be with the account before the relative-to-benchmark performance clock was turned on. We were always fully invested within that 30-day period. Some of our outside investment advisers decided that they could see the future for the market and would slowly phase the assets that they were given into the market. More often than not, this worked against the advisers.
The Positive Perception
This analysis aside, the concept of DCA does have some advantages. The true appeal is that it facilitates savings over time. Most young and many middle aged investors have modest assets and are slowly building up their savings, month-by-month and year-by-year. As excess funds become available, those funds are moved into a 401k plan or some other savings account or vehicle. By necessity, the savings are being dollar cost averaged into the market.
It is important not to confuse this continuous dollar cost averaging into a growing savings account with the optional decision to dollar cost average into (or out of) a portfolio of long term investments because of one’s fear of or excitement for the market, i.e. attempting to time the market.
Easy or Not?
To reemphasize a long-standing CornerCap principle, investing is easy … it’s the human stuff that’s not that easy.
Past performance is no guarantee of future results, and all investments are subject to risk of loss.