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A: It depends on your situation, objectives and personality.

Dollar cost averaging is an interesting example of an investment strategy that is both a good and a bad idea. Whether or not it’s the right thing to do depends largely on four factors:

  • Circumstances
  • Objectives
  • Risk/Return
  • Personality

Here’s a simple framework for deciding if dollar-cost averaging or lump sum investing is better for you?

Circumstances

First, you need to differentiate between regular investments made out of our current earnings[1] and staggering the investment of a large sum of money over time[2].

Having a regular savings and investment plan is ALWAYS the right thing to do. What we’ll be considering for the rest of this post is the latter scenario.

Second, you should zoom out and put the lump sum investment into context. For example, a $10,000 lump sum investment stocks may seem like a large investment for a young person to make. But a 25-year old[3] earning $85,000 per year will earn $5,134,169 over their career. Even adjusting for inflation, it’s still $2,325,215.93.

Third, you need to consider investment horizon. Australian shares have approximately a one in four chance of losing money in any given year. But they have only a one-in-ten (approx.) chance of losing money over a ten-year period[4]. You increase your odds of success if you give yourself time.

Objectives

Is your main priority to maximise return or minimise regret? There have been numerous studies demonstrating that dollar cost averaging results in a lower return most of the time.

For example, Vanguard used historical returns for the US, UK and Australia showed that dollar cost averaging underperformed lump sum investing around two thirds of the time.

VG DCA vs LS

Lump sum investing usually wins because it involves taking more investment risk. This makes sense as it results in a higher allocation to the share market sooner. Of course, this might not be appropriate for every investor. Creating a portfolio to suit an investor’s risk and return objectives is the best managed using asset allocation (see Risk/Return).

Dollar cost averaging is really a strategy for minimising potential regret. If the market goes up, you can console yourself that you’re at least partially invested. If the market goes down, you can feel good about holding some cash. Either way you can find a silver lining.

You can read more about the effects of regret on investment decision-making HERE.

Why do financial advisors often recommend dollar cost averaging? It might be because they recognise that it’s the right thing for the client given their circumstances, objectives, personality, etc. That’s great. Or, it could be because a client who regrets the outcome of an advisor’s recommendation is more likely to sack the advisor! That’s not so great.

This is a common problem with financial advice. It’s similar to the problem of defensive medicine.

Risk/Return

So far, I’ve assumed that you don’t have a view on the future risk and return of the investment. But what if you have good reasons to expect that future investment returns might be lower and/or the risk of negative returns might be higher?

Before you get too excited, I don’t mean having a hunch, waiting for a pullback or trying to time the market. What I’m referring to is long-term expected return analysis based on valuations and economic fundamentals. We’ll consider how to do this in a future newsletter.

If you are concerned about the risks of investing in the share market, then maybe what you really need to do is re-consider your asset allocation[5].

Personality

It’s ALWAYS a bad idea to ignore the human element in investing. While dollar cost averaging may be a sub-optimal investment strategy, it may still be a worthwhile idea.

Some people (i.e. my mother) are natural born worriers. These people agonise over the future. They wonder, how can I really be sure that now is a good time to invest? 100% certainty is impossible in investing.

This is where dollar cost averaging can really help. It helps people, who need to invest to meet their long-term needs and goals, to invest when they might otherwise be too scared. Having at least part of their money invested is a better outcome than letting the purchasing power of your savings be gradually eroded by inflation[6].

For some investors, having a plan to stick to is really important. For example, would you have had the courage to invest in Australian shares back in early 2009? The share market had just lost 43.5% in less than 6 months. Sticking to a strategy of dollar cost averaging would have meant that you continued to buy shares on the cheap. Those shares would be worth a lot more now.

Conversely, would you have kept investing in US shares back in early 2013 when US shares began to look expensive?[7]. If not, you would have missed out on a 104.3% gain (14.83% per year)[8] to March 2018.

In either case, dollar cost averaging helped investors limit their behavioural mistakes. That’s an important function of any investment strategy.

Takeaways

Few things in investing are either black or white, which is why it’s important to use a framework to help you make better investment decisions.

William Bernstein: “Having a suboptimal strategy you can stick with, is far better than an optimal strategy you can’t”

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Links

Meir Stateman: The Real Driver of Dollar Cost Averaging is Your Emotions, not Risk, June 2017

Vanguard: Dollar-cost averaging just means taking risk later, July 2012

Meir Statman: A Behavioural Framework for Dollar Cost Averaging, Fall 1995

Podcasts

William Bernstein: Lump Sum Investing vs. Dollar Cost Average

 

[1] For example, investing $100 out of each salary in shares.

[2] For example, inheriting $1,000,000 in cash and investing $100,000 per month in shares over 10 months).

[3] Earning $85,000 per year (the median Australian full-time wage in Nov 2017: http://www.abs.gov.au/ausstats/abs@.nsf/mf/6302.0), increasing at 2% per year for 40 years until retirement at 65. See: https://www.calcxml.com/do/ins07 .

[4] 1950 – 2012. The probability of negative return was 26.3% over 12-month periods and 11.8% over 10-year periods. Source: Andex.

[5] Or the mix of shares, bonds, cash and other assets in your portfolio.

[6] 2.5% inflation means that the value of $1 becomes approximately 78 cents after 10 years, 61 cents after 20 years and only 29 cents after 50 years.

[7] When the valuation of the S&P 500 index, measured by the forward price to earnings ratio, exceeded its long-term average.

[8] This assumes that dividends are reinvested and ignores taxes. See: https://dqydj.com/sp-500-return-calculator/

 

Grioli & Co. is an Authorised Representative (001258470) of Heuristic Investment Systems (AFSL: 276762).

 

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