On the way to work the other day, I heard a discussion of dollar-cost averaging on the radio. Yes, I listen to boring radio stations…
Overall, I was struck by how complex they made an otherwise simple concept sound. I thus thought I’d share some thoughts on the matter.
For background, dollar-cost averaging (DCA) refers to investing a chunk of money in equal dollar amounts over time as opposed to doing a lump sum, all-at-once investment.
Dollar-cost averaging has been billed both as a way to get more for your money (you automatically buy more shares at lower prices and fewer shares at higher prices) and as a strategy for reducing risk.
But those who think that DCA is a magical strategy that will improve their returns are mistaken. It won’t. In fact, on average, it does just the opposite.
The effects of averaging
Consider the following questions:
- Q: Which has higher expected returns, stocks or cash? A: Stocks.
- Q: Which has higher volatility, stocks or cash? A: Stocks.
- Q: What effect will having less money in the market (and more in cash) have on your (expected) returns? A: It will reduce your (expected) returns.
- Q: What effect will having less money in the market (and more in cash) have on the volatility of your portfolio? A: It will reduce portfolio volatility.
- Q: And what effect does DCA have on your portfolio? A: It reduces the amount of money you have in the market during the averaging-in period.
So, during the averaging-in period, DCA will reduce your expected returns, though it will also reduce risk. This is the classic risk-return tradeoff. Your portfolio will be (temporarily) more conservative than if you gone straight to your preferred allocation, so it should come as no surprise that you’ll get lower (expected) returns.
Risk vs. regret
This brings us to another point. Consider the following scenarios:
- You receive a large cash windfall and your preferred allocation is 60/40 stocks-to-bonds. What do you do? Put it straight into the 60/40 allocation? Or dollar-cost average into the market over time?
- You receive a large windfall that happens to already be in your preferred 60/40 allocation. What do you do? Leave well enough alone, or sell it (ignore tax implications, please) and then average back in over time?
For many people, their answers will differ. But why? A: Psychology. I would argue that many people are more regret-averse then they are risk-averse.
So, when handed a pile of cash, many people will opt to dribble the money into the market to avoid the possible regret associated with making a big move just before the market dives.
And when handed an already-allocated portfolio, many of these same people will leave well enough alone. If you don’t act (or don’t take big actions) you’re less likely to do something that you’ll regret.
Note: I’m ignoring the possibility that the windfall will change you need (or desire) to take risk, and thus change your preferred allocation. That’s certainly possible, but it’s another topic entirely.
In my experience, people don’t view inaction as an action even though it really is — i.e., they’re choosing not to act. So if inaction (or slow action) ends up being a mistake, there’s not the same level of regret attached.
Similarly, I suspect that many people feel the pain of losses more acutely than the joy of gains. So avoiding a potentially large loss at the expense of likely gains is perhaps a reasonable tradeoff for many.
The way forward
So what should you do? Mathematically, you should invest in your preferred allocation from the start. If you’re not comfortable doing so, then perhaps you don’t really prefer your “preferred” allocation. It may be too aggressive.
But more than anything, you should do in the short-term whatever prevents you from doing something stupid in the long-term. If going all-in might cause you to panic and do something stupid if the market turns against you, then perhaps you should DCA.
In other words, at the end of the day, you should do what works for you.
Relevant queries: dollar cost averaging coined.