Determining the best time to invest can be a nerve wracking business. Ideally, we’d all invest at the market’s low point, and watch our returns climb as we sat back and congratulated ourselves on our stellar timing and market acumen. Alas, we are stuck with real life, where markets are unpredictable and determining the very best time to buy nearly impossible.
One purported solution to this dilemma is dollar cost averaging. Rather than putting all of our money into the market at one time, we hold on to it, doling it out a little bit at a time, feeling secure that we are lowering our average share price with each investment.
Lower average purchase price
Dollar cost averaging is a strategy based on mathematical averages. Say, for example, you have $10,000 to invest. Rather than investing it all at once, you decide to invest $100 a month for a little over 8 years. That $100 will buy more shares in the months when prices are low, and fewer when they are high. The theory is that this helps to smooth the volatility of your investment by lowering your average price per share.
To an extent, the logic is indisputable. If you buy more shares when the price is low, and fewer when the price is high, your average price per share will be closer to the low side than the high side. That’s how averages work. The mistake is in assuming that reducing the volatility of the purchase price will have a similar effect on the performance of the investment.
Lower Returns
The presumed advantages of dollar cost averaging have been soundly debunked, unfortunately. In 1992, larger brains than mine compared dollar cost averaging to two other investment strategies – buy and hold and optimal rebalancing. While dollar cost averaging involves doling out your investment a little bit at time, both buy and hold and optimal rebalancing involve a single, lump sum investment.
Dollar cost averaging as a strategy came in dead last. Essentially, the reduction in average price from dollar cost averaging was more than offset by the loss of investment gain. More simply, the lower average share price doesn’t make up for the return lost by the money that is waiting to be invested. (The owners of those larger brains I mentioned are John Knight and Lewis Mandell, and they published their findings in the Financial Services Review (Vol.2, Issue 1) in a paper entitled “Nobody Gains from Dollar Cost Averaging: Analytical, Numerical and Empirical Results.”)
A comforting myth
It’s no great mystery why we find dollar cost averaging so appealing. As a concept, it plays nicely into our reservations about investing. None of us wants to risk putting the entirety of our investable capital into the market on the most expensive day of the year. Since stock prices are unpredictable, there is great allure in a strategy that takes the guesswork out of determining the very best time to buy, and minimizes the risk that we will have paid a premium for something we could have gotten more cheaply had we timed things differently. However, the evidence suggests that the risks of buying high are far lower than those of holding back and not putting all of our investable capital to work at one time.
Regular investing is important
No one – not Knight and Mandell, and certainly not me – is saying that regular investing is a poor strategy. It’s important to note that, from a definition standpoint, dollar cost averaging involves an amount of money you already have – like the $10,000 in our example above. On the other hand, Knight and Mandell note that regular investments from periodic income would be considered lump sum investments, since you are investing all of your available capital at one time.
The moral of the story is this – if you’ve earmarked it for investing, invest it, and let share prices fall (or not) where they may.