By: Steve Smith
Mike Tyson’s famous statement that “everyone has a plan until they get punched in the face” is often, and appropriately applied to stock market investors who claim they would love to see a market decline that would allow them to buy stocks on dip. Today’s investing advice is all about rolling with the punches, as it were.
Often when that sell-off comes, it’s deeper and steeper then expected, and planned purchases turn to paralysis, or worse, people get panicked into selling existing holdings.
This month’s long overdue and supposedly much desired 10% correction came in a dramatic fashion, with the bulk of it happening over four days. I wonder how many people managed to keep their cool, pull out their chopping list and scoop up shares of favored names, such as Facebook (FB) and Intel (INTC), which dropped 14 and 21 percent, respectively.
Unfortunately, most long-term investors try to time the market, or buy into sell-offs due to the disorienting “punch in the face” impact that usually accompanies market declines.
One common method to replace emotion with discipline is to use a dollar cost average (DCA) approach. This is the process of applying systemic stops at preset price levels; usually set at percentage terms and equal dollar amounts. This helps one avoid both buying too much on an initial dip, or completely missing the opportunity because one waited for the selling to stop or tried to find the bottom.
But a recent paper from Nathan Faber of NewFound Research asks whether dollar cost averaging is sound investing advice, and concludes DCA results in lower returns than Lump Sum Investing (LSI) .
Here are the summary bullet points:
- Dollar-cost averaging (DCA) versus lump sum investing (LSI) is often a difficult decision fraught with emotion.
- The historical and theoretical evidence contradicts the notion that DCA leads to better results from a return perspective, and only some measures of risk point to benefits in DCA.
- Rather than holding cash while implementing DCA, employing a risk managed strategy can lead to better DCA performance even in a muted growth environment.
- Ultimately, the best solution is the one that gets an investor into an appropriate portfolio, encourages them to stay on track for their long term financial goals, and appropriately manages any behavioral consequences along the way.
Dollar-cost averaging (DCA) is the process of investing equal amounts into an asset or a portfolio over a period of time at regular intervals. It is commonly thought of as a way to reduce the risk of investing at the worst possible time and seeing your investment immediately decline in value.
The most familiar form of dollar-cost averaging is regular investment directed toward retirement accounts. A fixed amount is deducted from each paycheck and typically invested within a 401(k) or IRA. When the securities in the account decline in value, more shares are purchased with the cash, and over the long run, the expectation is to invest at a favorable average price.
For this type of dollar-cost averaging, there is not a lot of input on the investor’s part; the cash is invested as it arrives. The process is involuntary once it is initiated.
A slightly different scenario for dollar-cost averaging happens when an investor has a lump sum to invest: the choice is to either invest it at once (“lump-sum investing”; LSI) or spread the investment over a specified time horizon using DCA.
In this case, the investor has options, and in this commentary we will explore some of the arguments for and against DCA with a lump sum with the intention of reducing timing risk in the market.
The Historical Case Against Dollar-Cost Averaging
Despite the conventional wisdom that DCA is a prudent idea, investors certainly have sacrificed a fair amount of return potential by doing it historically.
In their 2012 paper entitle Dollar-Cost Averaging Just Means Taking Risk Later, Vanguard looked at LSI versus DCA in the U.S., U.K., and Australia over rolling 10-year periods and found that for a 60/40 portfolio, LSI outperformed DCA about 2/3 of the time in each market.
If we assume that a lump sum is invested in the S&P 500 in equal monthly amounts over 12-months with the remaining balance held in cash earning the risk-free interest rate, we see a similar result over the period from 1926 to 2017.
Why does dollar-cost averaging look so bad?
In our previous commentary on Misattributing Bad Behavior , we discussed how the difference between investment return – equivalent to LSI – and investor return – equivalent to DCA – is partly due to the fact that investors are often making contributions in times of positive market returns. Over this 92 year period from 1926 to 2017, the market has had positive returns over 74% of the rolling 12-month periods. Holding cash and investing at a later date means forgoing some of these positive returns. From a theoretical basis, this opportunity cost is the equity risk premium: the expected excess return of equities over cash.
Given this empirical evidence, why is dollar-cost averaging still frequently touted as a superior investing strategy?
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