Pop quiz, hotshot. You found yourself with a large sum of money. Maybe it was an inheritance or from the sale of a property or business (it did not fall off the back of a truck). You don’t have an immediate need for cash, so you decide to invest it. If you dump it all in and the market tanks you could lose a lot of your principal. If you wait and the market takes off, you could miss a lot of gain. What do you do? What…do…you…do?
One rule of investing is that trying to time the market is generally a bad idea. We’ve all heard it. Peter Lynch, one of the greatest investors of his generation, once said “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Is there something in between?
Introducing Dollar Cost Averaging
First the theory. Dollar-Cost Averaging, or DCA, is a strategy that allows a person to invest the same dollar amount into their account at regular intervals. The purchases occur regardless of whether the market is up or down, and it helps reduce the impact of short-term volatility. Over time it can lead to buying more of an investment when it is cheaper and less of an investment when it is more expensive because the dollar amount being invested is kept the same. Let’s look at a real-life example:
Jack doesn’t think his pension and gold watch will be enough to get him through retirement, so he decides he wants to save on his own. Every month he puts away $100 into his investment account to buy shares of Traven, a publicly traded bus company. The first month it is trading for $20 a share so Jack buys 5 shares. The next month, after some really bad press, it fell to $10 a share so he buys 10 shares. The third month sees the company get back on track and shares jump to $25 each so Jack’s $100 buys 4 more shares. He paid a total of $300 and now owns 19 shares of Traven at an average cost of $15.79, despite two of the month’s purchases occurring at $20 a share or more.
Dollar Cost Averaging vs. Lump Sum Investing
Now that we have an alternative, is it any better than investing right away? In 2016 Vanguard released a comprehensive study to determine if you would be better off investing all your available money at once, or dollar cost averaging it in 12 equal parts over the course of a year. They checked every 12-month period from 1926 until 2015 using a balanced portfolio of 60% stocks and 40% bonds. The end result was that 68% of the time investing immediately was the better choice. In fact, even if you invested 100% in stocks or 100% in bonds, investing immediately still won 67% and 65% of the time.
But didn’t we just demonstrate the power of DCA? We did but here is the catch. The 32% of the time it was better occurred during the worst 12-month periods in terms of performance. If the market is falling DCA is a better option, in all other situations lump sum investing wins the day. If you could predict the market the answer would be obvious, but of course we can’t.
Since the market goes up more than it goes down, we believe you can tip the odds in your favor by investing a lump sum of money all at once instead of waiting. Before you ask, let us also say that both these approaches beat sitting on the money and waiting for a correction to jump in. While you are waiting to see if that correction turns into a recession the market may rebound and, in a few days or weeks, you are back to where you were before, still waiting.
Many of us use dollar cost averaging because we are saving AS we are earning rather than starting with all the money. Regular retirement plan contributions are a great example of this. If you do find yourself in this situation are there ever exceptions to the rule?
Yes, there are exceptions to every rule. Vanguard described it like this.
“For investors with a large cash balance on hand, the stakes are high. Out of worry that an investment will quickly lose value, they may gradually ease into the market. Such an approach can minimize feelings of regret by providing short-term, downside protection against a rapid decline in a portfolio’s value.”
If you are someone who would rather wait on the sidelines because investing all at once keeps you up at night, then dollar cost average is a great middle ground. You may give up some long-term returns, but it sure beats not playing at all.
When market timing makes sense
We believe some rules were meant to be broken, or at least bent. Let’s go over two examples.
First, you decide to dollar cost average in your inheritance because you couldn’t get past the fear of a big market drop. Low and behold, you were right, and it drops by 15%. Now is the time for timing! Your fear has come true but now you can buy in at a lower price. We would be all for moving the rest of your money into the market, or at least increasing your dollar cost averaging amount in to speed up the process. How do you know it won’t drop another 15%? You don’t, but you have already minimized the regret you would have had investing all at once and that should help you make the move.
Second, you are saving for retirement like clockwork through regular monthly contributions. After a significant market downturn (some % amount you have already decided on) you temporarily increase your contributions until the market gets back to where it was. But what if you don’t have any extra cash flow? You could invest a portion of money you set aside for shorter term goals (or the monthly savings you were putting aside for that goal) and when the market gets back to where it was, use your regular monthly retirement contributions to refill what you borrowed. We think this strategy can work because the money you are using for extra contributions is usually in a bank account or very safe investments not affected by the market downturn.
Again, we don’t know for certain that the market won’t keep going down, but history tells us that a rebound is the most likely outcome. Investing doesn’t live in the world of absolutes, but rather in probabilities and averages. If we can use market timing responsibly to tip the odds in your favor, and increase your chances of a higher return on average, those are rules worth breaking.