Why Dollar Cost Averaging is often the wrong decision for the right reasons
Dollar Cost Averaging is a popular investment strategy that nearly all Americans employ, although they may not realize it. Dollar Cost Averaging is simply investing a set amount into the markets on a regular and consistent schedule. The most common example of Dollar Cost Averaging is investing into a 401(k) or other employer sponsored retirement plan every pay period – a set dollar amount is set aside from each paycheck, contributed into the participant’s account, and invested per the instructions established for that participant. This happens every pay period, regardless of what is happening with the markets.
Dollar Cost Averaging is simply investing a set amount into the markets on a regular and consistent schedule. The trick is to continue investing no matter what is happening with the markets.
Similarly, one can Dollar Cost Average a lump sum of cash available for investment. Rather than investing the full amount on any particular day, one could evenly distribute purchases over a period of weeks or months. For example, if you have $100,000 available for investment, you could invest $25,000 per month for 4 months in lieu of deploying the full $100,00 all at once. The trick is to continue investing on this schedule no matter the “then current” market conditions.
Generally speaking, we may consider a Dollar Cost Averaging strategy with a lump sum of cash if that lump sum represents 10% or more of your investable assets.
Imagine this…Your best friend comes up to you and offers to flip a coin and give you $20 if it lands on heads. But if it lands on tails, you have to give your friend $20. Would you take that bet? If you’re like the majority of people, you probably wouldn’t.
Human beings are emotional, irrational creatures. We are hardwired to avoid pain, and will often do so at our own demise. Psychologists refer to this behavior as Loss Aversion, which stipulates that we, as a species, prefer to avoid a loss than to obtain an equivalent gain – we’d rather not lose $20 than obtain $20. Research shows this behavior is measurable in our brains. In our coin flip example, the part of our brain that processes reward does not “light up” to the same degree when analyzing the value potential of $20 as the part of our brain that processes pain and the potential loss of $20.
Dollar Cost Averaging can provide a logical process to help us to minimize fear of loss and regret. In this way it is more a risk mitigation strategy than an investment strategy.
This behavioral trait is the primary reason why an investor would choose to Dollar Cost Average rather than invest a lump sum. Employing a Dollar Cost Averaging strategy “feels better” because you are not locking yourself into the share price on whatever day you happen to choose to deploy cash. You may worry, “What if I invest all my cash and the market drops a few days later?”. This is Loss Aversion – the potential regret of losing money in the market outweighs the potential opportunity. Dollar Cost Averaging psychologically helps us to minimize these fears of loss and regret. In this way it is more a risk mitigation strategy than an investment strategy.
The million-dollar question…does employing a Dollar Cost Averaging strategy help to improve investment results? The short answer is, typically no. Over time markets tend to go up, so it’s often better mathematically to simply invest a lump sum all at once as the drag of maintaining high cash balances through a Dollar Cost Averaging strategy can negatively impact investment results.
Let’s review the annualized returns of the S&P 500 and the Barclays US Aggregate Bond Index for the last 30 years to represent equity and bond market performance respectively. Since 1990, the S&P 500 experienced 6 negative years, meaning US Equities were positive on an annualized basis 80% of the time for the last 30 years. The Barclays US Aggregate Bond Index experienced 3 negative years, meaning core US bonds were positive on an annualized basis 90% of the time since 1990.
Historically, markets tend to be positive. As such, Dollar Cost Averaging generally has a reduced likelihood of outperforming a lump sum investment.
While we all know past performance is no guarantee of future results, it is quite clear history demonstrates that markets tend to be positive. Assuming history is a decent predictor of future trends, mathematically investors have a higher probability of success by investing a lump sum rather than Dollar Cost Averaging.
The exception to this rule comes with market downturns. Generally, an investor who keeps additional cash on hand to continually buy into the market as prices fall or remain depressed will experience better investment results over time than another who was already fully invested before the downturn. And that, ladies and gents, is the tradeoff – we can fully invest a lump sum and risk the significantly lower historical probability that the markets turn negative for a period of time, or we can Dollar Cost Average and risk that the markets continue to climb upwards.
To illustrate the costs and benefits of Dollar Cost Averaging in up and down markets, let’s review the growth of $100,000 in 2008, the first year of the Great Recession, and 2019, a highly positive market year. We will look at the performance of both equity (S&P 500) and fixed income (AGG) markets, and compare that to a Pension Benchmark portfolio of 60% equity and 40% fixed income either invested as a Lump Sum on January 1, invested via a 6-month Dollar Cost Averaging strategy (6-mo DCA), and finally invested via a 12-month Dollar Cost Averaging Strategy (12-mo DCA).
As we would expect, in a prolonged market downturn as experienced through 2008 the 12-month Dollar Cost Averaging strategy outperformed both the 6-month DCA as well as the Lump Sum. In this case, it benefited our hypothetical investor to keep extra cash and invest throughout the year as the markets trended downwards. Conversely, in 2019 when markets trended up throughout the year, the 12-month Dollar Cost Averaging strategy underperformed the other strategies. In this case the additional cash held throughout the year created a drag on the investment results.
As discussed previously, on an annualized basis the markets tend to be positive far more often than they are negative. As such, achieving outperformance is less likely via a longer-term Dollar Cost Averaging strategy.
Ok, I know what you’re thinking… “Hang on! If Dollar Cost Averaging typically does not produce better investment results, then why would I do it?” Remember, humans are not rational creatures – we often don’t make decisions based on facts but rather based on our emotions. When it comes to investing a lump sum of cash, our emotions will often flash big red warning lights in our brains because it doesn’t matter if the math supports a statistical likelihood of achieving a better result over the long term by investing all at once…we know we can still experience the less likely scenario of a market downturn closely following our lump sum investment. It is that fear of loss and regret that disrupts the logic, and causes irrational behavior.
We are, by nature, risk-averse because we all innately want to survive. Money helps us to survive. When we think about investing our life savings into the markets, we essentially trigger a “fight or flight” response in our brains. Employing a Dollar Cost Averaging strategy can help to wrangle in those crazed reactions and force us stick to a more logical plan.
Humans are not rational creatures – we often make decisions based on emotion, not fact. Employing a Dollar Cost Averaging strategy can help to put our emotions in check and keep us on track to acheive our goals.
Think of a risk/reward scale where the reward side represents earning money on your investments and the risk side represents your mental sanity. We have to strike a balance between creating and implementing your personal, needs-based investment strategy on one side and on the other making sure you aren’t tearing your hair out while running in circles around your dining room table, screaming. At the end of the day, the most important thing we can do together is to come up with an investment plan you can stick with in the tough times – this can arguably have the largest impact on your future financial success or failure.
At the end of March 2020, we had experienced the fastest and steepest market decline since the Great Depression, with uncertainty and fear about COVID-19 on the rise. Today, if you could pull a “Marty McFly”, jump in the DeLorean returning to April 1, 2020, and “predict” a swift market rebound with double-digit positive returns to finish the year…people would have either said “Great April Fool’s joke!” or “You’re nuts!”.
There are two critical lessons that we, as investors, can take away from 2020.
First, the Federal government will step in to buttress our economy when necessary. If anything, the bar for what is expected of the Feds, both politically and financially, has been raised. When the pandemic was just starting, the Federal Reserve’s decision to act quickly and with exponential magnitude compared to previous recessions was very likely the primary ballast against a market free-fall. Whether the repercussions of that monetary policy will be positive or negative in the long run, time will tell…but we wouldn’t be surprised if such action became more commonplace in future financial crises, in which case we can hope their length and intensity may consequentially be reduced.
Second, it is clearer than ever that trying to time the markets is a losing game. We can’t wait for “the bottom” of a market cycle or a dramatic down-swing to pull the trigger and invest – sitting on the sidelines waiting could prove far more costly as you run the risk of the markets continuing to climb, as discussed above. Bottom line…come up with a plan you’re comfortable with and get going. What’s more, don’t interrupt your plans mid-way through – allowing emotions to get in your way defeats the purpose of developing a logical investment schedule, and can only exacerbate the risk of allowing the market to “run away” without you.
2020 is the perfect example – if our hypothetical investor had decided in January to deploy cash in equal installments over 6 months, but then “got scared” in March with the market drop and decided to pause his purchases for the next 2 months (April and May), he would have missed out on the rebound that no one was expecting. Now could that have gone the other way and been beneficial to our hypothetical investor? Possibly, but then again if he was too scared to “get in” after the drop, wouldn’t he be more scared if the markets had continued to remain depressed? At what point would he have restarted his investment schedule?
Remember, markets are smart and based on future predictions – they will often turn a corner in advance of any positive trends affecting them. Interrupting your investment plans can be just as detrimental as never starting them at all. The truth is that no one knows how the markets will move on any given day. Ultimately, we believe TIME IN the markets is far more important than TIMING the markets.
While Dollar Cost Averaging often leads to sub-optimal investment results, we cannot underestimate its value in helping us to curb the irrational, emotional urges that can cause us to make mistakes. You must weigh the opportunity cost of investing a lump sum or deploying cash over time relative to your own mental well-being. It is far better to stick with your plan (even if it’s sub-optimal) than to take a left turn and veer off course.
Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. Dollar cost averaging cannot guarantee a profit or protect against a loss, and you should consider your financial ability to continue purchases through periods of low price levels. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. All investments are subject to risk. There is no assurance that any investment strategy will be successful.