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Dollar-Cost Averaging Isn't Dumb

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Millions of people use dollar-cost averaging to ease their way into their portfolio positions. But is dollar-cost averaging a dumb move?

A recent study from Vanguard (link opens PDF file) has gotten a lot of attention by suggesting that dollar-cost averaging isn't the optimal way to put a lump sum of money to work. But even though the results of the study show that dollar-cost averaging often leads to worse returns than simply dumping all your cash into the market at the same time, the intangible benefits from using the strategy may well outweigh any lost profits.

Giving up money
The gist of dollar-cost averaging is that by putting a fixed amount of new money to work at regular intervals, you'll benefit from volatility in the market. In particular, when shares of a stock or fund drop temporarily, your fixed dollar amount will buy more shares at exactly the time when the investment presents the best value proposition. On the other hand, when shares are expensive, your fixed investment buys fewer of them. If the price of an investment zigs and zags upward and downward while eventually landing in pretty much the same place it started, then dollar-cost averaging can eke out a positive return even when the stock price reflects flat or even slightly negative performance.

As the study notes, however, the problem with dollar-cost averaging comes when investments tend to move upward over time. By failing to buy at your earliest opportunity, you give up the often higher returns of being fully invested. And with interest rates on cash balances being close to zero at the moment, the opportunity cost of having a considerable chunk of cash on the sidelines is particularly high.

When the Vanguard study looked at historical performance for U.S. asset classes, it found that on average, using dollar-cost averaging to invest a lump sum over 12 months underperformed simply investing it all on Day 1 about two-thirds of the time, regardless of whether the portfolio was stock-heavy, bond-heavy, or relatively balanced. A similar look at the U.K. and Australia over shorter historical periods showed similar results.

When dollar-cost averaging makes the most sense
Predictably, the study has drawn a lot of criticism from financial planners, who argue that other factors come into play and support dollar-cost averaging. For instance, investing everything at the same time runs the very real psychological risk of suffering immediate losses after making the initial investment, which can wreak havoc with investors' confidence and lead them to reject sound investing strategies after short-term losses due to bad timing.

But the rest of the study actually quantifies that risk. After 10 years of investing with a $1 million portfolio, on half of all historical occasions, using lump-sum techniques beat using dollar-cost averaging by $55,000 or more. But a quarter of the time, dollar-cost averaging saved $43,000 or more -- and on the true outliers, the strategy saved more than $200,000 5% of the time. That risk reduction is meaningful, even if it came at the cost of greater returns much of the time.

What those results suggest is that using dollar-cost averaging for your riskiest plays may make the most sense. For instance, high-beta materials stocks Freeport-McMoRan Copper & Gold (NYSE: FCX  ) , ArcelorMittal (NYSE: MT  ) , and Teck Resources (NYSE: TCK  ) have proven extremely vulnerable to worsening conditions in the global economy, with shares moving abruptly when economic news provides more information about the future. Using dollar-cost averaging for those stocks could help you avoid calamitous downward movements while letting you take advantage of potential gains.

Conversely, low-volatility plays probably don't need the extra protection of dollar-cost averaging. If low-beta stocks Abbott Labs (NYSE: ABT  ) and Altria (NYSE: MO  ) continue their past ways, then you'll likely end up better off simply taking the plunge.

Be smart
Of course, for many of us, the luxury of lump-sum investing isn't available because we don't have lump sums to invest. If you're regularly investing out of your paycheck, don't be afraid to use dollar-cost averaging. It will serve you well, and more important, it's the best way to keep the discipline of putting money toward your savings regularly.

Whether you dollar-cost average or invest all at once, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Read/Post Comments (2) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 06, 2012, at 2:48 PM, JustSavvy wrote:

    I'd take the argument one step further. When evaluating how to invest excess cash from a paycheck, assuming you're as fully invested as is sensible for your financial position, you actually garner the benefits of dollar cost averaging while executing a strategy of lump-sum investment.

    For example, if you have a savings of $50k and you have $500 extra each month that you want to invest, you are effectively electing to make a lump sum investment of all of your available cash (that $500 you're saving). Just because you are regularly acting on this strategy doesn't take away from the fact that you're upfront decision is to invest as much as possible. Additionally, owning to the recurring nature of the fixed-dollar investments, you should benefit from market volatility (as is expected with a dollar cost averaging strategy).

    Regardless of whether or not I'm right about how to interpret the investment strategy above, it has historically made a lot of sense to invest regularly and immediately.

  • Report this Comment On November 06, 2012, at 5:32 PM, Darwood11 wrote:

    Incremental investing, which is what "Dollar Cost Averaging" is, made me a lot of money in 2008-9.

    While the market was dropping, I added to my stock holdings. I bought more stock each month over a period of months. My spouse included her automatic monthly investing.

    I was somewhat "blue" in 2009 because I had purchased assets for more than they were currently worth. I thought "Darn, I made a big mistake."

    But at the market improved, so did the value of those assets.

    I've never been a "market timer" or a short term investor. The recent stock market panic taught me a valuable lesson, and my portfolio reflects it.

    As far as I am concerned, DCA works.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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